SIM MODULE BOOK

ELEMENTS OF ECONOMICS

Module Book

ELEMENTS OF ECONOMICS
Module Book Developer :

Tan Khay Boon

Production

SIM Global Education

Module Book

SIM Global Education 2013

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No part of this material may be reproduced in any form or by any means without
permission in writing from SIM Global Education
First Version @ October 2013

Table of Content
Introduction

Session 1: Fundamental of Microeconomics

11

Session 2: Demand, Supply and Market Equilibrium

22

Session 3: Elasticity

37

Session 4: Efficiency. Production and Costs

48

Session 5: Perfect Competition

64

Session 6: Monopoly

75

Session 7: Fundamental of Macroeconomics

88

Session 8: Inflation

100

Session 9: Unemployment

110

Session 10: Aggregate Expenditure and Fiscal Policy

121

Session 11: Money and Monetary Policy

133

Session 12: Aggregate Demand and Aggregate Supply

147

Module Book

ELEMENTS OF ECONOMICS
INTRODUCTION
Content
This foundational module can be distinguished into two important sections:
microeconomics and macroeconomics. Microeconomics is mainly the study of individual
households and firms interacting on a market level to satisfy their aims. Macroeconomics
is the study of entire economic systems and how the government utilises specific tools to
effect changes. Both sections revolve around the concept of limited resources used by
the all players in the economic system. The module will help understand the powerful
economic forces that shape and influence our everyday lives.
Module Aims
The aims of this module are to:
1. Understand the basic mechanisms that govern both microeconomics and
macroeconomics.
2. Master the basic skills necessary for numerical and graphical analysis.
3. Appreciation and application of the economic tools learned to real-life scenarios.
Learning Outcomes
On completion of this module, a participant will typically be able to:
1.

Show a detailed knowledge and understanding of:

i)
ii)

The nature of economics and the concept of limited resources.

Basic microeconomic economic concepts like, demand, supply and market
equilibrium.
Production and costs in both the short-run and the long-run.
The study of different market structures.
Basic macroeconomic concepts such as GDP, business cycles and savings.
The major goals of governments on: growth, inflation and unemployment.

iii)
iv)
v)
vi)

vii) The role of money and how monetary policy is used in macroeconomic
management.
2.

Demonstrate module specific skills with respect to:

i)
ii)
iii)
iv)

Interpreting the basic features of graphs used in economic models.

Explain the interaction of supply and demand.
Comparing the characteristics of different market structures.
Demonstrating an understanding of basic macroeconomic concepts, including the
circular flow of income.
Appreciation of important economic indicators like inflation rates, real gross
domestic product and unemployment rates.

v)

3.

Show cognitive skills with respect to:

i)

Understanding how the concept of scarcity affects everyone and how decisions are
made with respect to the problem.
Appreciating of the economic nature of the firm, especially the relationship between
the firms output and costs.
Recognising how various market structures, national income, employment, the
consumer price index and monetary policy are important components of an
economic system.

ii)
iii)

4.

Demonstrate transferable skills in:

i)
ii)
iii)
iv)
v)

Conceptual and analytical reasoning.

Numeracy.
Communication.
Economics in the context of a situation.
Problem formulation and decision-making.

Delivery of Module and Lesson Plan

Session

Topic

Session Learning Outcomes

At the completion of this session,

participants will be able to:
1.

3.

4.

Fundamental of
Microeconomics

Demand, Supply and

Market Equilibrium

Elasticity

1. Define economics and explain the

core concepts of Microeconomics.
2. Explain the questions that
economists try to answer.
3. Discuss the economic systems.
4. Interpret the graphs used in
economic models.
5. Define and calculate slope.
1. Define demand and distinguish
between quantity demanded and
demand.
2. Explain what determines demand.
3. Define supply and distinguish
between quantity supplied and
supply.
4. Explain what determines supply.
5. Explain the equilibrium in a
market.
6. Explain the effects of changes in
demand and supply in the market.
1. Define and explain the factors
that influence the price elasticity
of demand.
2. Calculate the price elasticity of
demand.
3. Explain effect of price elasticity
on total revenue
4. Calculate and explain the income
elasticity of demand.
5. Calculate and explain the crossprice elasticity of demand.

Efficiency, Production 1. Define and explain consumer

and Costs
surplus and producer surplus.
2. Discuss the concept of efficiency.
3. Explain how to measure a firms
cost of production and profit.
4. Explain the relationship between
a firms output and labour

Prescribed
Text,
Readings
and/or
Activities

Module
book
Session 1

Module
book
Session 2

Module
book
Session 3

Module
book
Session 4

employed in the short run.

5. Explain the relationship between
a firms output and costs in the
long run.
6. Derive and explain a firms longrun average cost curve.
5.

6.

7.

8.

Perfect Competition

Monopoly

Fundamental of
Macroeconomics

Inflation

1. Discuss the characteristics of a

perfectly competitive industry
2. Discuss the characteristics of a
perfectly competitive firm
3. Explain a perfectly competitive
firms profit-maximising choices.
4. Explain how output, price, and
profit are determined in a
perfectly competitive firm
5. Explain the short run equilibrium
of a perfectly competitive firm.
6. Explain the long run equilibrium
of a perfectly competitive firm.
1. Define monopoly
2. Explain how monopoly arises
3. Distinguish between single-price
monopoly and pricediscriminating monopoly.
4. Explain how a single-price
monopoly determines its output
and price.
5. Compare the performance of a
single-price monopoly with
perfect competition.
1. Define GDP
2. Explain how GDP is measured.
3. Distinguish between nominal
GDP and real GDP.
4. Explain the limitations of GDP in
indicating standard of living.
5. Define recession
6. Explain the formation of business
cycle
1. Define inflation.
2. Discuss the types of inflation.
3. Apply consumer price index to
measure inflation.
4. Explain the limitation of consumer

Module
book
Session 5

Module
book
Session 6

Module
book
Session 7

Module

price index in measuring cost of

living
5. Apply GDP deflator to measure
inflation
6. Discuss the costs of inflation
9.

10.

Unemployment

Aggregate Expenditure
and Fiscal Policy

1. Define unemployment
2. Calculate labour force statistics.
3. Describe the types of
unemployment.
4. Discuss the costs of
unemployment
5. Explain the methods to reduce
unemployment
1.
2.
3.
4.
5.
6.

Derive the aggregate expenditure

function.
Explain the components of
aggregate expenditure.
Analyze the equilibrium of the
economy using Keynesian Cross
Model.
Define and explain fiscal policy
Analyze the effects of fiscal
policy using Keynesian Cross
Model.
Describe and analyze the impact
of budget deficit and surplus

book
Session 8

Module
book
Session 9

Module
book
Session 10

11.

Money and Monetary

Policy

1. Define money and explain its

functions.
2. Explain the money creation
process and derive the money
multiplier.
Module
3. Define money demand and
book
money supply.
Session 11
4. Explain how central bank can
influence the money supply.
5. Explain how the equilibrium
interest rate is established.
6. Explain the mechanism of
monetary policy.

12.

Aggregate Demand and

Aggregate Supply

1. Define and explain the influences

on aggregate demand.
Module
2. Define and explain the influences
book
on aggregate supply.
Session 12
3. Explain the equilibrium in the
economy.
4. Analyse changes in aggregate

demand and aggregate supply.

5. Apply the aggregate demand
aggregate supply framework to
analyze economy

Teaching and Learning Methods

Students will learn through a combination of lectures and practical activities.
Students will be expected to learn independently by carrying out reading and
directed study beyond that available within taught classes.
Indicative Readings
Textbooks required
Supplementary
reading
Online Journals

Tan Khay Boon, Elements of Economics Module Book, SIM

Global Education, 2013

Robin Bade & Michael Parkin, 2009, Essential

Foundations of Economics, 4th Edition, Pearson
International Edition
Sloman, J. 2006, Economics, FT Pearson, Harlow.
Use of online databases like EBSCO and references to:
Journal of Economic Perspectives, The Economist, The
Financial Times, Guardian, BBC News Online, Business
Times, etc.

Assessment/coursework
All assessments will comply with the SIM Rules and Regulations. To satisfy
module requirements students must:
1. Satisfactorily complete and present on due dates their assignment work. A
penalty of 20% of the total marks will be imposed for late submission. A
submission later than 1 calendar day past deadline will receive a zero mark.
2. In order to pass the module, all assignments and the final examination must
be completed in a satisfactory manner.
3. All cases of plagiarism in regard to module assessment will be dealt with
severely as outlined in SIMs policy on plagiarism.
4. 100 or more hours (including class attendance and assignments) should be
spent on the module.
Specific for this module are the following requirements:
Weighting between components A and B - A: 60% B: 40%
Element Description

Element
Type

%
of % of
Component
Assessment

Summative

100%

Component A (Controlled
Conditions)

Examination (150

60%

minutes)
Component B (Assignments)

1. Quiz 1
Macroeconomic
Concepts
2. Quiz 2
Microeconomic
Concepts
3. Class Participation

Summative

37.5%

15%
Dates TBA

Summative

37.5%

15%
Dates TBA

Summative

25%

10%.
100%

Total

10

ELEMENT OF ECONOMICS
SESSION 1
FUNDAMANETAL OF MICROECONOMICS
At the end of the session, students should be able to:
1.
Define economics and explain the core concepts of Microeconomics.
2.
Explain the questions that economists try to answer.
3.
Discuss the economic systems.
4.
Interpret the graphs used in economic models.
5.
Define and calculate slope.
_________________________________________________________________
1.

Introduction

In this session, we begin with an introduction to the definition of economics and some
key economic terms. Next we discuss the different economic systems. Then we analyze
the graphs which are used very commonly in economic analysis and finally we learn how
to calculate the slope of the graph.
Economics is a social science concerns with the production and consumption of goods
and services. It focuses on how society manages its limited resources to produce output
and distribute output to its people. It aims to answer three fundamental questions in a
society: what to produce, how best to produce and for whom to produce.
2.

Definition of Economics and Key Terms

2.1

Types of Resources

Human have desire for goods and services; know as their wants. To satisfy these wants,
resources are needed to produce goods and services. There are four types of resources:
Land: This refer to the physical ground that plants and animals are living and buildings
can be built on it. It also refers to the natural resources such as mineral deposits and
other possessions that are created by nature.
Labour: This refers to the human effort in producing output in producing output,
represented by workers in the labour force. The knowledge and skills of the workers are
called human capital.
Capital: This refers to man-made machines that use to facilitate the production of goods
and services. It includes all the simple and complex tools, offices and building and

11

infrastructures such as airport. The productivity of capital is dependent on the level of

technology.
Entrepreneurial ability: This refers to the ability to organize land, labour and capital to
produce useful goods and services. The human effort that provide this ability is known as
an entrepreneur.
2.2

Classifications of Economics

Economics is classified into Microeconomics and Macroeconomics

Microeconomics is the study of individual parts of the economy. It involves the study of
the behaviour of a consumer in making choices, the behaviour of a firm in deciding price
and output, and the behaviour of the market of a product. It concerns with consumers and
firms make decisions and how they interact in specific markers.
Macroeconomics is the study of economy as a whole. It involves the study of the
performance of a country, the general price of goods and service sin a country, the
situation of unemployment in a country and how to promote the growth of a country and
the distribution of output in the country. It concerns with total amount of spending and
also total output produced in a country.
In real life economic analysis are often very complicated and many issues tend to affect
each other. To simplify the analysis, economic agents often single out the main issues to
be explored and assume the other issues to remain constant.
The assumption of other things equal is known as the ceteris paribus assumption. The
advantage of making this assumption is that when two issues are singled out, they can be
expressed in a diagram that makes analysis much easier.
2.3

Scarcity, Choices and Opportunity Cost

Human wants are unlimited but the resources that are needed to produce the goods and
services to satisfy the wants are limited. Thus resources are scarce and this create the
problem of scarcity. Scarcity means society has less to offer than people wish to have.
Due to scarcity, human cannot have all it desires and hence we have to make choices.
This means whenever we make a choice, we will have to give up the other options. The
value of the next best alternative that we give up represents a cost of our choice. This cost
is known as the opportunity cost.
Note that every choice involves giving up something else and hence there is sacrifice.
When individual is making a choice, there may be more than one alternative that need to

12

give up. The opportunity cost of this choice is only the value of the next best alternative
that needs to give up, not the value of all alternatives forgone.
2.4

Rational Choice and Marginal Analysis

Since resources are limited, individuals need to make the correct choice or the rational
choices to maximize their own welfare. Every choice provides some benefits to the
individual but incur some costs to the individual too.
For example, when deciding to spend $10 to buy a short, an individual has the benefit of
wearing the short but have to give up the $10 which can be used for other goods or
services. This the individual needs to weigh up the costs and benefits of any activity and
choose the item which has the greatest benefit relative to its cost, including opportunity
cost.
Once an activity is decided, the agent also needs to determine to what extent the activity
should be involved. For example, how many units of a product should a consumer
consume? The rational choices involve weighing up marginal costs and marginal
benefits.
Marginal benefit is the additional benefit of doing a little bit more (or one more unit) of
an activity. Usually when the quantity of an activity increases, the marginal benefits tend
to decrease.
Marginal cost is the additional cost of doing a little bit more (or one more unit) of an
activity. Usually when the quantity of an activity increases, the marginal cost tend to
increase.
If the marginal benefits of an activity exceeds its marginal cost, a rational person will
want to pursue more of the activity. However, if the marginal cost of an activity exceeds
its marginal benefit, a rational person will want to reduce the quantity of the activity
In other words, as long as the marginal benefit exceeds the marginal cost, a rational agent
should increase the level of activity. Conversely, if the marginal benefit is less than the
marginal cost, the agent will be better off if he reduce the level of activity. The optimum
level of any activity is at the level when marginal benefit equals marginal cost.
2.5

Positive and Normative Economics

Economists can help government to devise economic policy. Two types of statement can
be used in policy analysis. They are positive and normative statements.
Positive statement is a statement of fact that can be tested. It concerns with what is.

13

For example, a positive statement is "If the price of a product increases, people will buy
less". This is a positive statement because we can test whether it is true that people really
buy less when the price of the product increase. Even when people did not buy less when
the price increase, this is still a positive statement.
Normative statement is a statement of value. It concerns with what should be and it
involves a value judgement.
For example, a normative statement is "It is bad for price to increase". This is a
normative statement because it involves a value judgement and it cannot be tested. The
buyer may think it is bad for the price to increase but a higher price benefits the seller and
hence there is no way to establish whether the statement is right or wrong.
Economists can contribute to questions of policy only in a positive statement.
3.

Economic Systems

All societies are faced with the problem of scarcity but they may have different ways to
solve this problem. It depends on the degree of government control of the economy. One
extreme is the government control all resources and all activities in an economy. This is
known as the command or planned economy. The other extreme is the government only
plays the minimum roles of national defence and maintain law and order and the market
determines what types of product to produce, how to produce and for whom to produce.
This is known as the capitalist economy. Most of the economies has a mixture of these
two systems, known as the mixed economy.
3.1

Command or Planned Economy

In a command economy, all economic decisions are made by the government. It is

usually associated with a socialist or communist economic system, where land and capital
are state owned. The state allocates the resources of the economy, plans the output of
each industry and firm and distributes the output between consumers.
Central planning has the advantage of relying in the decisions of a few politicians that
may be in the interests of society as a whole. It could direct the nations resources in
accordance with specific national goals. High growth rate could be achieved if the
government directed large amount of resources into investment.
3.2

Free Market Economy

In a free market economy, there is no government intervention at all. All decisions are
taken by individuals and firms, which are assumed to act in their own self-interest. This
is usually associated with a pure capitalist system where land and capital are privately

14

owned. Individuals are free to make their own choices. Firms seek to maximize profits,
consumers seek to maximize value from purchases and workers maximize wages in jobs.
Free market economy relies on the price mechanism to allocate resources. Prices respond
to shortages and surplus. Shortages cause prices to rise, thus attract more resources to
produce the products with higher price. Surplus cause prices to fall, thus lesser resources
will be allocated in the products with lower price. Prices will continue to change until all
shortages or surpluses are eliminated.
The advantages of a free market economy are its functions automatically. There is no
need for government to coordinate economic decisions. Competition in the market keeps
prices down and acts as an incentive to firms to become more efficient. When resources
are more efficiently used, more output can be produced and consumed and hence the
economy will achieve a higher level of welfare.
3.3

Mixed Economy and the Role of Government

In practice, all economies are a mixture of the two. In a mixed economy, the government
may be actively involved in producing certain goods and services while the private sector
take over the production of other goods and services. In addition, the government may
impose taxes, provide subsidies or implement legislation to control the relative price of
goods and resources, to manipulate the distribution of income and to affect the production
and consumption pattern of certain goods and services.
The most important aspects of government function are to tackle the macroeconomics
issues like inflation, unemployment, low or negative economic growth (recession) and
balance of payments problems.
4

Interpreting Economic Graphs

The economics analysis in this course involves many diagrams to explain the relationship
between various issues. For example, in the demand analysis, the relationship between
price and quantity demanded will be explored. In the cost analysis, the relationship
between cost of production and quantity of output produced will be analyzed. It is
important to have a good understanding of the relationship between economic issues.
Consider two economic variables Y and X and are measured in the Y axis and the X axis
respectively in a graph. Some common diagrams between two variables X and Y are
shown below:

15

(a)

Negative relationship

In the negative relationship, a higher value of one variable is associated with a lower
value of the other variable, resulting in a downward sloping graph. This relationship
appears in the demand curve discussed in Session 2.
Figure 1.1: Negative Relationship
Y

X
(b)

Positive relationship

In the positive relationship, a higher value of one variable is associated with a higher
value of the other variable, resulting in an upward sloping graph. This relationship
appears in the supply curve discussed in Session 2.
Figure 1.2: Positive Relationship
Y

16

(c)

Horizontal line

In the horizontal line, the Y axis takes a certain fixed value regardless of the value of the
X axis. This no matter how big or how small the X axis value is, the Y axis value
remains unchanged. This relationship appears in the perfectly elastic demand curve in
Session 3.
Figure 1.3: Horizontal Line
Y

X
(d)

Vertical line

In the vertical line, the X axis takes a certain fixed value regardless of the value of the Y
axis. This no matter how big or how small the Y axis value is, the X axis value remains
unchanged. This relationship appears in the perfectly inelastic demand curve in Session
3.
Figure 1.4: Vertical Line
Y

17

(e)

U-shaped curve

In the U-shaped curve, initially as the value of the X axis increases, the value of the Y
axis decreases and hence the relationship between X and Y are negative. Eventually
when the X axis increases, the Y axis value also increase and the relationship between X
and Y becomes positive. This relationship appears in the marginal cost curve diagram in
Session 4.
Figure 1.5: U-shaped Curve
Y

X
(f)

Inverted U-shaped

In the Inverted U-shaped curve, initially as the value of the X axis increases, the value of
the Y axis also increases and hence the relationship between X and Y are positive.
Eventually when the value of the X axis increases, the Y axis value decreases and the
relationship between X and Y becomes negative. This relationship appears in the
marginal product curve diagram in Session 4.
Figure 1.6: Inverted U-shaped Curve
Y

18

Calculation of the Slope of Graph

(a)

Calculation of the slope of a straight line

To calculate the slope of a straight line, we identify any two points A and B on the
straight line, say (X1, Y1) and (X2, Y2). The slope of the straight line can be calculated by
the formula Slope = (Y2 - Y1)/(X2 - X1)
Figure 1.7: Slope of a line
Y
B
Y2
A
Y1

X1
(b)

X2

Calculation of the slope of a curve

To calculate the slope of a curve at a particular point, we draw a tangent line to that point
and then calculate the slope of the tangent line. The tangent line is a straight line that just
touches the curve at a particular point. In Figure 1.8 below, the slope at point A of the
curve is the slope of the tangent line that just touches point A
Figure 1.8: Slope of a curve
Y

Tangent line
A

Y1

X
X1

19

Discussion Questions

Question 1
Which of the following is a positive statement?
(a) If the firm increases its price, its profit will decrease
(b) The firm should increase its price
(c) The best business practice for the firm now is to advertise vigorously
(d) The firm is not performing up to expectation
Question 2
Which of the following is not considered as labour?
(a) A production worker of a factory
(b) A teacher of a school
(c) A doctor of a government hospital
(d) A founder of a company
Question 3
If a person makes a choice of value $10, we can conclude that the opportunity cost of this
choice must be
(a) more than $10
(b) the same as $10
(c) less than $10
(d) $10 or less than $10
Question 4
Consider a person given 4 options 1,2,3 and 4 with values $10, $5, $3 and $2
respectively. What is the opportunity cost if he choose option 1?
(a) $20
(b) $15
(c) $1
(d) $5

20

Question 5
Given two points on a straight line graph (1,7) and (2,12), what is the slope of this line?
(a)
(b)
(c)
(d)

3
4
5
6

Question 6
(a)

What are the disadvantages of a command economy?

(b)

What are the disadvantages of a free market economy?

Question 7
Refer to the diagram below. What is the slope of the curve at point A?
Y
Tangent line
8
A
4

X
2

21

ELEMENT OF ECONOMICS
SESSION 2
DEMAND, SUPPLY AND MARKET EQUILIBRIUM
At the end of the session, students should be able to:
1.
Define demand and distinguish between quantity demanded and demand.
2.
Explain what determines demand.
3.
Define supply and distinguish between quantity supplied and supply.
4.
Explain what determines supply.
5.
Explain the equilibrium in a market.
6.
Explain the effects of changes in demand and supply in the market.
___________________________________________________________________
1.

Introduction

In this lecture, we begin with an introduction to the definition and concepts of demand.
Next we introduce the definition and concepts of supply. Then we combine the demand
and supply to analyse equilibrium in a market. Finally, we analyze the effects of changes
in the price and quantity when demand and supply changes in the market
2.

Demand and Demand Curve

Demand is the relationship between price of a product and the quantity of the product
which consumers are willing and able to buy. For example, the demand for bread
involves finding out how many units of bread consumers want to buy if the price per loaf
is $1, $1.50, $2 etc.
At each price, the quantity which consumers are willing and able to buy is called the
quantity demanded of the product. Over a range of price, we can establish a range of
quantity demanded for the product and this forms the demand for the product.
2.1

Law of demand

It is generally observed that when the price of a product increases, its quantity demanded
decreases. Conversely, when the price of the product decreases, its quantity demanded
increases. There is an inverse relationship between price and quantity demanded and this
is known as the law of demand.
The law of demand states that the quantity of a product demanded in a given time period
varies inversely with its price, other things constant.

22

The law of demand is based on two reasons: Substitution effect and Income effect.
Every product more or less has some substitutes although some products may have closer
substitutes than the others. In general when the price of a product increases, consumers
will source for its substitutes and buy less of this product. Thus the quantity demanded of
this product decreases follow by an increase in its price. This is known as the
substitution effect.
Consumers must have a certain amount of money to be able to buy the products. This
amount of money, expressed in dollars, is the money income of the consumer. But the
purchasing power of this amount of money is dependent on the price of the product and
this is the real income of the consumer. When the price of a product decreases, the
purchasing power of consumers income, or the real income increases. The consumer
can buy more with the same amount of money and this will increase the consumer's
ability to buy more of the product. This is known as the income effect.
2.2

Demand Schedule and Demand curve

Demand schedule is a table showing the quantity demanded of a product at different

price. A typical demand schedule for a product, say bread, is shown in Table 2.1
Table 2.1: Demand Schedule for Bread
Price of bread
$0.80
$1.00
$1.20
$1.40
$1.60

Quantity Demanded of Bread

140
130
120
110
100

The demand curve is a diagram representing the demand schedule. It is drawn with Price
on the Y-axis and quantity demanded on the X-axis. The demand curve is always
downward sloping due to the law of demand.
Note that demand refers to the entire price range while quantity demanded refers to only
at a particular price. When price decreases, quantity demanded increases. When price
increases, quantity demanded decreases. Changes in price are reflected as movements
along the same demand curve. A typical demand curve is shown in Figure 2.1.

23

Figure 2.1: Demand Curve

Price
A
P1
B

P2

Demand curve
Q1

Q2

Quantity demanded

An individual point on the demand curve, such as point A or point B in Figure 2.1 shows
the quantity demanded at a particular price. Any movement along a demand curve
reflects a change in quantity demanded.
When a product becomes cheaper, consumers buy more. This is known as an increase in
quantity demanded. It is reflected as a movement down the demand curve. Thus when
price decreases from P1 to P2, the quantity demanded increases from Q1 to Q2, as shown
in Figure 2.1
When a product becomes more expensive, consumers buy less. This is known as a
decrease in quantity demanded and is reflected as a movement up the demand curve.

2.3

Changes in demand

The demand for a product is not a specific quantity but the entire relation between price
and quantity demanded. A change in demand is reflected by a shift in the entire curve.
A given demand curve isolates the relation between the price of a good and the quantity
demanded when other factors that could affect demand remain unchanged. Once these
factors change, the demand curve will be shifted.
When there is a positive factor change that results in an increase in demand, the demand
curve shifts to the right from D1 to D2, as shown in Figure 2.2. This means at the same
price, the consumers will want to buy a larger quantity of the product.

24

Figure 2.2: Increase in Demand

Price

P1
D1
Q2

Q1

D2
Quantity demanded

When there is a negative factor change that results in a decrease in demand, the demand
curve shifts to the left. This means at the same price, the consumers will want to buy a
smaller quantity of the product.
2.4

Factors that Affect Demand

Price is not the only factor that determines buying decision. The willingness and ability
of consumers to buy a product is also influenced by many other factors. Some of the
common factors that affect demand are as follow:
(a)

Income of Consumers

Consumer's ability to buy a product is determined by his or her income. However, when
income increases, a consumer's response will depend on the nature of the product.
For normal goods, when consumer income increases, they are willing and able to buy
more units at each price and to pay more per unit at each quantity, thus the demand curve
shifts to the right. For example, a consumer may travel overseas mote frequently when
his income increases.
For inferior goods, their demand decreases as income increases. Consumers tend to buy
less of these goods when they are richer because they will switch to the higher category
or better of the product. For example, a consumer may buy less instant noodle when his
income increases as he may switch to other more expensive food that are more nutritious
The demand curve shifts to the left when income rises.
(b)

Prices of related goods

When the price of a good change, it may influence the demand of another good which is
related. Two products are related in either in the form of complements or as substitutes.

25

Two goods are substitutes if an increase in the price of one leads to an increase in the
demand for the other.
Consider Good A and Good B as substitutes. If the price of B increases, consumers that
initially purchase B will now switch to buy A. Thus even though price of A is
unchanged, consumers want to buy more of A and hence the entire demand curve shifts
right. The demand for Good A increases.
Two goods are complements if an increase in the price of one leads to a decrease in the
demand for the other.
Consider Good A and Good B as complements. If the price of B decreases, consumers
will buy more of Good B. Thus for Good B it is an increase in quantity demanded. But
since Good B must be used together with Good A, when consumers buy more Good B
they must also buy more Good A, even though price of Good A is unchanged. Thus the
entire demand curve for Good A shifts to the right. The demand for Good A increases.
(c)

Consumer Expectation of Future Price

A change in consumer expectations, such as a change in price expectation in the future

can also affect demand.
If consumers expect the price of a good to increase in the future, they may increase their
demand for the product now, before prices go up. Thus the demand for the product
increase, the demand curve shifts right.
On the other hand, an expectations of a lower price in the future will encourage some
consumers to postpone their purchases, thereby reducing current demand. Thus the
demand curve shifts left.
(d)

Consumers Population

If the number of consumers in the market changes, such as population increases, the
demand for a product may increase. When there are more consumers for a product, a
larger quantity will be demanded even though price is unchanged. Thus the entire
demand curve shifts to the right.
(e)

Consumer Preferences

Preferences or tastes are individual likes and dislikes as a consumer. Any change in
preference towards a product will increase the demand that product.
If consumers have a stronger preference for a product, they will buy more even though
the price is the same as before. The entire demand curve shifts to the right and the

26

demand increases. Conversely, a decrease in consumer preference will reduce the

demand for the product, thereby shifting the demand curve to the left.
3.

Supply and Supply Curve

Supply is the relationship between price and the quantity of a product that producers are
willing and able to supply. It indicates how much of the good producers are both willing
and able to offer for sale per period at each possible price, other things constant.
3.1

Law of supply

There is a positive relationship between quantity supplied and price. When price
increases quantity supplied also increases. The reason is that to supply more of a
product, more resources are needed. Initially when resources are plentiful, it is relatively
to obtain the resource at a low cost. Eventually when resources become scarce, it become
more costly to acquire resources. Thus a higher price is needed to induce producers to
acquire more resources to produce more.
The law of supply states that the quantity supplied is usually directly related to its price,
other things constant.
The lower the price, the smaller the quantity supplied. The higher the price, the greater
the quantity supplied.
3.2

Supply schedule and supply curve

The amount that producers would like to supply at various prices is shown in a supply
schedule. A typical supply schedule for a product, say bread, is shown in Table 2.2
Table 2.2 Supply Schedule of Bread
Price of bread
$0.80
$1.00
$1.20
$1.40
$1.60

Quantity Supplied of Bread

100
110
120
130
140

When express in a diagram with price on the Y-axis and quantity supplied in the X-axis,
it is the supply curve. The supply curve expresses the relation between the price of a
good and the quantity supplied, other things constant.

27

From the law of supply, the supply curve is upward sloping. A higher price induces
suppliers to supply more of a product. This is reflected as a movement along the supply
curve. A typical supply curve is shown in Figure 2.3.
Figure 2.3: Supply Curve
Price
B
P2
A

P1

Q1

Q2

Quantity supplied

If the price is higher, producers will respond by supplying more of the product. This is
known as an increase in quantity supplied. It is shown as a upward movement along the
same supply curve. In Figure 2.3, when price increases from P1 to P2, the quantity
supplied increases from Q1 to Q2.
If the price is lower, producers will produce less of the product. This is known as an
decrease in quantity supplied and reflected as a downward movement along the same
supply curve.
3.3

Determinants of supply

Supply decision is not solely determined by price alone. Even if the price of a product is
unchanged, there might be other determinants or factors that cause the producer to supply
a different quantity of the product at the same price.
If any of the factor of supply were to change, the entire supply curve will shift. A
favourable change will shift the supply to the right, resulting in a larger quantity supplied
at the same price. This is shown in Figure 2.4

28

Figure 2.4: Increase in Supply

Price
S1
P1

S2

Q2

Q1

Quantity supplied

A non-favourable change will shift the supply to the left, resulting in a smaller quantity
supplied at the same price.
The factors that affect the supply curve are as follows:
(1)

Technology

Technology represents the knowhow to combine resources most efficiently in producing

a product. If there is an improvement in the technology, more output can be produced
with the same resources. Thus the producer will have greater ability to produce more
output even at the same price. This is reflected by a shift to the right of a supply curve.
(2)

Prices of resources

Resources are needed to produce output and suppliers need to incur costs to acquire the
relevant resources. If the resources, such as land, labour and capital become cheaper. the
cost of production decreases and the suppliers will be more willing and able to produce
more of the output, even though the price remains unchanged. Thus the entire supply
curve shifts to the right and the supply increases.
(3)

Prices of Alternative goods

Alternatives goods are goods that use some of the same resources as are used to produce
the good under consideration. For example, a piece of land of may be able to grow either
vegetables or fruits and initially the farmer is growing both. A fall in the price of the
alternative good, say vegetables, will make the production of fruits more attractive and
the farmer may allocate more land to grow fruits and less to grow vegetables, even
though the price of fruits is unchanged.
In general , consider 2 goods, Goods A and B that require the same resources to produce.
If price of Good A drops, producers will produce less of Good A and will switch to

29

produce more Good B, even though price of Good B is unchanged. Thus there is a
decrease in the quantity supplied of Good A. But the supply of Good B increases.
(4)

Expectation of Future Price by Producers

If the producer expect the price of a product, especially a durable product, such as houses
to increase in the future, the producer may prefer to reduce their current supply and await
the higher price. Thus at the same price, less will be supplied now and the supply curve
shifts left.
Conversely, if the producers expect the price of the product to fall in the future, the
producer may prefer to supply more now before the price decrease. Thus the supply
curve shifts right.
(5)

Number of producers

If the number of producer increases, more output will be supplied at the same price. The
entire supply curve shifts to the right and the supply increases.
If the number decreases, the supply curve will shift to the left and supply decreases.
4

The Market Analysis

A market is a place where producers meet the consumers. It is illustrated by combining a

demand curve and a supply curve in the same diagram. The Y-axis is price and the Xaxis is now quantity. The intersection point illustrates market equilibrium. The
corresponding price and quantity are known as the equilibrium price and equilibrium
quantity respectively. At this price, quantity demanded equals quantity supplied. There
is no shortage and surplus and price will have no tendency to change.
Suppliers and demanders have different views of price, since demanders pay the price
and suppliers receive it. As price rises, consumers reduce their quantity demanded but
producers increase their quantity supplied. A products market sorts out the conflicting
price perspectives of suppliers and demanders.
4.1

The Market Equilibrium

By bringing together market demand and supply together, the market equilibrium can be
determined. The equilibrium point is where the supply curve intersects demand curve.
This is shown at Point E in Figure 2.5. The corresponding price is the equilibrium price
PE and the corresponding quantity is the equilibrium quantity QE.

30

Figure 2.5: A Market Diagram

Price
Supply curve
E

PE

Demand curve
Quantity

QE

If the price is higher than the market equilibrium price, the quantity supplied exceeds the
quantity demanded, resulting in an excess quantity supplied, or a surplus. A surplus
creates downward pressure on the price. This is shown in Figure 2.6.
Figure 2.6: Surplus in the Market
Price
Supply curve
Surplus

P1

E
PE
Demand curve
Q1

Q2

Quantity

If the market price is P1 which is higher than PE, then the producer will want to supply a
quantity Q2 while the consumers only want to consumer up to a quantity Q1. The
producer will be stuck with unsold quantity and will be under pressure to reduce the price
in order to sell more. Thus price will continue to decrease until there is no more surplus.
If the price is lower than the market equilibrium price, the quantity demanded exceeds the
quantity supplied, resulting in an excess quantity demanded, or a shortage. A shortage
creates upward pressure on the price. This is shown in Figure 2.7

31

Figure 2.7: Shortage in the Market

Price
Supply curve
E
PE
P2

Demand curve
Q1

Q2

Quantity

If the market price is P2 which is lower than PE, then the producer will want to supply a
small quantity Q1 while the consumers only want to consume a large quantity Q2. There
will be insufficient of the product to meet every consumer's need and those who have a
stronger desire for the product will have to offer a higher price to obtain the product.
Thus the consumers will be under pressure to offer higher price and the price will
continue to increase until there is no more shortage.
In general, the price of a product will continue to adjust upwards and downwards until the
quantity demanded exactly equals the quantity supplied. The surplus give rise to unsold
goods and producers will be under pressure to reduce price. The shortage will prompt
consumers to offer a higher price to get the product. There will be no further adjustment
once an equilibrium is reached. At this point the market is at equilibrium because the
quantity consumers are willing and able to buy equals the quantity producers are willing
and able to sell. There is no shortage and surplus and no pressure for change.
4.2

Impact of Changes in Demand

Note that the equilibrium price is determined by the demand and supply curves. If
demand or supply curve shifts the equilibrium price and quantity will be different. When
the determinants of demand change such that demand curve shifts right, equilibrium price
and quantity will increase. When the determinants of supply changes such that supply
curve shifts left, equilibrium price increases while quantity decreases.
Starting with an initial equilibrium, if any of the factors of demand changes in a way that
increases demand, the demand curve will shift to the right. The result is that the new
equilibrium price and quantity will be higher than the previous one. This is shown in
Figure 2.8

32

Figure 2.8: Increase in Demand

Price
Supply curve
P2

E1

P1

E2

D2

D1
Q1

4.3

Q2

Quantity

Impact of Changes in Supply

Starting with an initial equilibrium, if any of the factors of supply changes in a way that
decreases supply, the supply curve will shift to the left. This is shown in Figure 2.9. The
result is that the new equilibrium price will be higher but the new equilibrium quantity
will be lower.
Figure 2.9: Decrease in Supply
Price
S2
P2

E2

S1

P1

E1
Demand curve
Q1

Q2

33

Quantity

5.

Discussion Questions

Question 1
What will cause the demand curve to shift as shown in the diagram?
Price

D2

D1
Quantity demanded

(a) An increase in consumers income

(b) A drop in the price of complements
(c) Consumers taste to the product is stronger
(d) A decrease in the price of substitutes
Question 2
Which will cause the supply curve to shift as shown in the diagram?
Price
S1
S2

Quantity
(a) An improvement in technology
(b) Workers demand for a higher wage
(c) Price of raw materials increases
(d)Producers expect price to increase in the near future

34

Question 3
What will occur when the market price of a product is higher than the equilibrium level?
(a) Producers produce more
(b) Consumers buy less
(c) a surplus will occur
(d) all of the above
Question 4
What will happen when the market price is higher than the market equilibrium price?
(a)
(b)
(c)
(d)

The demand curve will shifts left

The supply curve will shifts right
The price will eventually decrease due to surplus
The price will eventually increase due to shortage

Question 5
Which of the following will result in a higher price and quantity in a market?
(a) An improvement in the technology
(b) An increase in consumers income
(c) An increase in the price of resources
(d) An increase in the price of complements
Question 6
Consider a car market in an economy. Analyse the impact on the car market when the
following occurs:
(a)

An increase in the price of petrol

(b)

A decrease in consumers income

(c)

The workers in the car industry demand for higher wages

(d)

An increase in the price of steel

35

Question 7
Using the demand and supply framework, analyse the effects on the computer market
when the following occurs:
(a) A decrease in the wages of workers
(b) An increase in consumer preferences in internet and information technology
(c) An increase in the price of software
(d) An improvement in technology producing computers

36

ELEMENTS OF ECONOMICS
SESSION 3
ELASTICITY
At the end of the session, students should be able to:
1.
2.
3.
4.

Define and explain the factors that influence the price elasticity of demand.
Calculate the price elasticity of demand.
Explain effect of price elasticity on total revenue
Calculate and explain the income elasticity of demand
Calculate and explain the cross-price elasticity of demand.

5.
____________________________________________________________
1.

Introduction

In this lecture, we begin with an introduction to the definition of price elasticity of

demand. Next we introduce another type of demand elasticity known as the income
elasticity of demand. Finally we introduce the third type of demand elasticity known as
cross-price elasticity of demand.
To analyze a market effectively, it is important to learn more about the shapes of the
demand and supply curves. The shape of the demand curve is affected by how
responsive people are to economic changes such as a change in price or a change in
consumer income. Elasticity is a tool used to measure such responsiveness. In this
lecture, we are going to explore three demand elasticities. The emphasis is on applying
the concept of elasticity to make rational business decisions.
2.

Price Elasticity of Demand

Due to the law of demand, when price decreases quantity demanded increases. But the
magnitude of the change is determined by the elasticity of the demand curve.
2.1

Definition of Price elasticity of demand

Price elasticity of demand (PED) is defined as percentage change in quantity demanded

divided by percentage change in price. It is always negative since price and quantity
demanded are inversely related. When analyse price elasticity of demand we always
ignore the negative sign and consider the absolute value.
Price elasticity of demand is the percentage change in the quantity demand divided by the
percentage change in price. It is denoted by the symbol PED and its formula is:

37

PED = % change in quantity demanded = change in quantity demanded X price

% change in price
change in price
quantity
If the absolute value exceeds 1, it means % change in quantity demanded is larger than %
change in price. Consumers are very responsive to the price change and the demand is
known as elastic. The demand curve will be relatively flat.
If the absolute value is less than 1, it means % change in quantity demanded is smaller
than % change in price. Consumers are not responsive to the price change and the
demand is known as inelastic. The demand curve will be relatively steep.
If the absolute value equals 1, it means % change in quantity demanded is the same as %
change in price. Consumers respond to the price change in an equal proportion and the
demand is known as unit elastic. This is mainly a theoretical concept.
If the value equals 0, it means % change in quantity demanded is zero regardless of the %
change in price. Demand is totally inelastic and the demand curve is vertical.
If the absolute value is infinite, it means % change in price is zero regardless of the %
change in quantity demanded. Demand is totally elastic; the demand curve is horizontal.
2.1

Calculating Price Elasticity of Demand

If the price changes from P1 to P2 and the quantity demanded changes from Q1 to Q2,
there are two ways to calculate the price elasticity of demand.
The first method is known as the point method and the elasticity calculated is known as
point elasticity. The formula is:
PED

Q2 - Q1
P 2 - P1

P1 .
Q1

This elasticity is measured on the original point and hence the original price and quantity
are used in the calculation. Note that when calculating changes, we always use the final
value minus the initial value for both price and quantity.
The second method is known as the midpoint method or the arc method and the elasticity
calculated is known as mid-point elasticity or arc elasticity. The formula is:
PED

Q2 - Q1
P 2 - P1

(P1 + P2)/2
(Q1 + Q2)/2

This elasticity is measured on the distance between the two points and hence the midpoint
price and quantity are used in the calculation.

38

Based on the law of demand, price and quantity demanded always move in opposite
directions. If price change is positive, change in quantity demanded must be negative.
Thus the term change in quantity divided by change in price is always negative. Since
price and quantity are always positive, the price elasticity of demand has a negative sign.
Numerical Example:
If price increases from $0.9 to $1.10 and the quantity demanded decreases from 105 to
95, the price elasticity of demand using the point formula is
PED = 95 - 105 X
1.1 - 0.9

0.9
105

= -10 X
0.2

0.9
105

= -0.43

The price elasticity of demand using the midpoint formula is

PED = 95 - 105 X
1.1 - 0.9

2.2

(0.9 + 1.1)/2
(105 + 95)/2

= -10 X
0.2

1
= -0.5
100

Interpreting Price Elasticity of Demand

When interpreting the price elasticity of demand, we ignore the negative sign and take the
absolute value, PED .
If the percentage change in quantity demanded is smaller than the percentage change in
price, PED has a value between 0 and 1, and demand is inelastic. An inelastic demand
curve is relatively steeper. This is shown in Figure 3.1
Figure 3.1 Inelastic Demand Curve
Price

Demand curve

Quantity demanded

39

If the percentage change in quantity demanded exceeds the percentage change in price,
PED has a value of greater than 1, and demand is elastic. A elastic demand curve is
relatively flatter. This is shown in Figure 3.2
Figure 3.2 Elastic Demand Curve
Price

Demand curve

Quantity demanded
If the percentage change in quantity demanded just equals the percentage change in price,
PED has a value of 1, and demand is unit elastic. In this case, the diagram will be a
downward sloping curve known as a rectangular hyperbola. This is more of a theoretical
case where in real life it is difficult to find a product that has a unit elastic demand.
If the percentage change in quantity demand is zero, the PED = 0 and the demand is
perfectly inelastic. The demand curve is vertical. vertical demand curve indicates that
the quantity demanded does not vary at all when the price changes. This is shown in
Figure 3.3
Figure 3.3 Perfectly Inelastic Demand Curve
Price

Demand curve

Quantity demanded
and the demand is perfectly
If the percentage change in price is zero, the PED =
elastic. The demand curve is horizontal. A horizontal demand curve indicates that the
consumer will demand all that is offered for sale at the given price. If the price rises
above the given price, the quantity demanded drops to zero. This is shown in Figure 3.4.

40

Figure 3.4 Perfectly Elastic Demand Curve

Price

Demand curve

Quantity demanded

2.2

Determinants of Price Elasticity of Demand

Most of the products have either elastic or inelastic price elasticity of demand and
different products tend to have different price elasticity of demand. For some products, a
small percentage change in the price will result in a large percentage change in the
quantity demanded. For other products, a large percentage change in price only results in
a small percentage change in quantity demanded. Some factors that affect the price
elasticity of demand are as follows:
(a)

Availability of substitutes

A product that has many close substitutes will have high value of elasticity (elastic
demand). A small price change will induce a large change in quantity demanded since
the consumers can easily switch to the close substitutes. The greater the availability of
substitutes for a good and the closer these substitutes, the greater the price elasticity of
demand.
(b)

Proportion of the consumers budget spent on the good

A product that occupies a large portion of consumer income will have elastic demand.
When the price of this product increases consumers will reduce the consumption of this
product substantially. Thus the larger the proportion of the consumers budget for a
product, the greater will be the response from the consumer when the price change, so the
more elastic will be the demand for the item.
(c)

Time frame

Consumers can substitute lower-priced goods for higher-priced goods but this usually
takes time. The longer the adjustment period considered, the greater the ability to

41

substitute away from relatively higher-priced products toward lower-priced alternatives,

so the more responsive the change in quantity demanded is to a given change in price.
2.3

Price Elasticity of Demand and Total Revenue

One of the most important applications of price elasticity of demand is to analyse the
effect on total revenue when price changes. Total revenue (TR), or total sales, is defined
as price multiply by quantity. Other things equal, a firm may seek to maximize its total
revenue by changing its price.
There are two effects when a firm changes its price. When the price is increased, the
benefit is that the firm can earn more from each unit of the good but the disadvantage is
that consumers will buy less. Conversely when the firm reduces its price, it earns less
from each unit sold but consumers may buy more. The overall effect on total revenue
depends on the price elasticity of demand.
If the demand is elastic, this means consumers are very responsive to price. A small
reduction in price will induce a large increase in quantity demanded. In this case the firm
can earn a higher total revenue by reducing its price. This is shown in Figure 3.5
Figure 3.5 Elastic Demand Curve and Total Revenue
Price
P1

-TR

P2

Demand curve
+TR
Quantity demanded
Q1

Q2

If the demand is inelastic, this means consumers are not responsive to price. Even a large
reduction in price did not attract more sales. But a large increase in price only results in a
small decrease in quantity demanded. In this case the firm can earn a higher total revenue
by increasing its price. This is shown in Figure 3.6.

42

Figure 3.6 Inelastic Demand Curve and Total Revenue

Price
P1

+TR
Demand curve

P2
-TR
Quantity demanded
Q 1 Q2
In general, if the demand is elastic, a lower price leads to a higher total revenue. But if
the demand is inelastic, a higher price will lead to a higher total revenue. If the demand is
unit elastic, total revenue remains unchanged when price changes. This is true only if the
midpoint formula is used in calculating the price elasticity of demand.
3.

Income Elasticity of Demand

The second type of demand elasticity is the income elasticity of demand. It measures the
reponsiveness of demand to a change in consumer income (I). It is defined as percentage
change in demand divided by percentage change in income and is denoted by IED.
3.1

Calculating Income Elasticity of Demand

To calculate the income elasticity of demand, we can use the formula:

IED =

% change in demand = change in demand X

% change in income
change in income

income
demand

If income changes from I1 to I2 and the quantity demanded changes from Q1 to Q2, there
are two ways to calculate the income elasticity of demand.
The point formula is IED
The midpoint formula is IED

Q2 - Q 1
I 2 - I1
=

Q2 - Q 1
I2 - I1

43

I1 .
Q1
X

(I1 + I2)/2
(Q1 + Q2)/2

3.2

Classification of Income Elasticity of Demand

If the income elasticity of demand of a product is positive, consumers buy more of this
product when their incomes increase. This product is known as a normal good.
If the income elasticity of demand is between 0 and 1, this product is classified as a
necessity. Consumers buy more but by a smaller proportion than the increase in income.
If the income elasticity of demand exceeds 1, this means consumers buy proportionately
more of this product than their increase in income. This product is classified as a luxury.
If the income elasticity of demand of a product is negative, consumers buy less of this
product when their incomes increase. This product is known as an inferior good.
4.

Cross Price Elasticity of Demand

The third type of elasticity is known as the cross elasticity of demand or cross price
elasticity of demand. The responsiveness of demand for one good to changes in the price
of another good is called the cross-price elasticity of demand. It is defined as the
percentage change in the demand for one good divided by the percentage change in the
price of another good. For goods A and B, the cross-price elasticity is defined as %
change in quantity of Good A divided by % change in price of Good B. It is denoted by
the symbol CED
4.1

Calculating Cross Price Elasticity of Demand

To calculate the cross elasticity of demand between two products A and B, we can use
the formula:
CED = % change in demand of A = change in quantity of A X
% change in price of B
change in price of B

price of B
quantity of A

If the price of Good B changes from PB1 to PB2 and the quantity demanded of Good A
changes from QA1 to QA2, the two ways to calculate the cross price elasticity of demand
are:
The point formula is CED
The midpoint formula is CED

QA2 - QA1
PB2 PB1
=

QA2 - QA1
PB2 PB1

44

PB1 .
QA1
X

(PB2 + PB1)/2
(QA2 + QA1)/2

4.2

Classification of Cross Price Elasticity of Demand

If the cross-price elasticity of demand is negative, it means demand for good A increases
when price of good B decreases. This implies consumers buy more of good A when
good B becomes cheaper. Thus good A and B must be complements.
If the cross-price elasticity of demand is positive, it means demand for good A increases
when price of good B increases. This implies consumers buy more of good A when good
B becomes more expensive. Thus good A and B must be substitutes.
If the cross-price elasticity is zero, it implies that the two goods are unrelated.

Discussion Questions

Question 1
When the price of a product increases from $1 to $2, its quantity demanded decreases
from 10 units to 5 units. Using midpoint or arc formula, we can conclude that
(a) the product is demand elastic
(b) the product is demand unit elastic
(c) the product is demand inelastic
(d) the product is demand perfectly inelastic
Question 2
Refer to the diagram that follows:
Price

D2
D1

Quantity demanded

Which of the statement best describes the diagram?

(a) D1 is more price elastic than D2
(b) D1 is more price inelastic than D2
(c) D1 is more income elastic than D2
(d) D1 is more income inelastic than D2

45

Question 3
If a seller knows that the demand for his product is price inelastic, he should ______ in
order to earn more revenue.
(a) decrease his price
(b) increase his price
(c) keep his price unchanged
(d) produce more output
Question 4
Given that the income elasticity of demand of a product is 2.3, we can conclude that
(a) the product is price elastic
(b) the product is normal and a necessity
(c) the product is inferior
(d) the product is normal and a luxury
Question 5
Given that the cross price elasticity of demand between two products is -1.8, we can
conclude that
(a) the two product are substitutes
(b) the two products are complements
(c) one of the product is a necessity and the other product is a luxury
(d) one of the product is normal and the other product is inferior
Question 6
You are given the following information for a product X:
Initial value
Final value

Quantity of Good X demanded

6
10

Price of Good X
$8
$6

(a)

Calculate the price elasticity of demand of X using the point method .

(b)

Calculate the price elasticity of demand of X using the midpoint method.

(c)

Based on (b), classify the elasticity of demand for the product.

(d)

What should you do if you wish to earn a higher revenue from selling X?

46

Question 7
You are given the following information for a product X, a related product Y and the
income of a consumer.

Initial value
Final value

Quantity of Good
X demanded
6
10

Price of Good X
$8
$6

Income of
consumers
$100
$200

Price of Good Y
$5
$8

(a)

Calculate the income elasticity of demand for X using the point method.

(b)

How do you classify the product X based on income elasticity of demand?

(c)

Calculate the cross elasticity of demand between X and Y using the point method.

(d)

What is the relationship between product X and Y?

47

ELEMENTS OF ECONOMICS
SESSION 4
EFFICIENCY, PRODUCTION AND COST
At the end of the session, students should be able to:
1.
2.
3.
4.
5.
6.

Define and explain consumer surplus and producer surplus.

Discuss the concept of efficiency.
Explain how to measure a firms cost of production and profit.
Explain the relationship between a firms output and labour employed in the short
run.
Explain the relationship between a firms output and costs in the short run.
Derive and explain a firms long-run production and its average cost curve.

_____________________________________________________________
1.

Introduction

In this session, we begin with an introduction to the concept of consumer surplus and
producer surplus. Next we combine the two surpluses to analyse the concept of
efficiency. Then we introduce the theory of production and finally we discuss the
concept of costs in both the short run and the long run.
2.

Consumer Surplus and Producer Surplus

The concept of consumer surplus and producer surplus are important to analyze the
welfare of a society. If the market is efficient, using the market system to allocate
resources will also maximize the welfare of the society by maximizing the sum of
producer and consumer surplus.
2.1

Consumer Surplus

For all consumers, there is a maximum price that each would pay for a product. Each
consumers maximum is called his willingness to pay, and it measures how much that
buyers values the good. Buyer will be eager to buy at a price less than his willingness to
pay and will refuse to buy at a price more than his willingness to pay.
So long as the price, determined by the market system, is lower than the price that the
consumers are willing to pay, there will be extra welfare enjoyed by the consumer when
he buy this product at the market price. This extra welfare is called the consumer surplus.
Consumer surplus is the amount a buyer is willing to pay for a good minus the amount
the buyer actually pays for it. It measures the benefits to buyers of participating in a
market.

48

Consumer surplus is closely related to the demand curve for a product. In fact, the
demand curve illustrates the willingness of consumers to pay for a certain quantity of a
product. The area below the demand curve and above the price is the consumer surplus.
This is shown in Figure 4.1.
Figure 4.1: Consumer Surplus
Price
Supply curve
Consumer
PE Surplus

Demand curve
Quantity

QE
5.2

Producer Surplus

Producers will be willing to produce and supply a product if the price received exceeds
the cost of supply. Cost here refers to opportunity cost, not just the cost of hiring
resources. The producer must cover his cost in the business and hence the price that
allow him to cover his cost is the lowest price a producer must receive for his effort, cost
is a measure of his willingness to sell. Each producer will be eager to supply at a price
higher than his cost and will refuse to supply at a price less than his cost.
So long as the price, determined by the market system, is higher than the price that the
cost incurred by producer, there will be extra welfare enjoyed by the producer when he
produced and sell this product at the market price. This extra welfare is called the
consumer surplus.
Producer surplus is the amount a seller is paid minus the cost of production. It measures
the benefit to sellers of participating in a market. Since the supply curve reflects seller
costs, it can be used to measure producer surplus. The area below the price and above the
supply curve measures the producer surplus in a market. This is shown in Figure 4.2.

49

Figure 4.2: Producer Surplus

Price
Supply curve
PE

E
Producer
Surplus
Demand curve
Quantity

QE
2.3

Market Efficiency

Consumer surplus and producer surplus are the basic tools that economists use to study
the welfare of buyers and sellers in a market. We are interested to find out whether
changes in allocation of resources can increase welfare of people in an economy.
If an allocation of resources maximizes total surplus, the allocation exhibits efficiency.
An allocation is not efficient if a good is not produced by the lowest cost sellers or if a
good is not consumed by the highest value buyers.
Figure 4.3

Welfare of a Society

Price
Supply curve
Consumer
PE Surplus (A)
Producer
Surplus (B)

Demand curve
QE

Quantity

When a market reaches the equilibrium of supply and demand, the total surplus is the
maximum. Free markets allocate the supply of goods to the buyers with highest value

50

and allocate the demand for goods to sellers who with least cost, thus maximizes the sum
of consumer surplus (A) and producer surplus (B), as shown in Figure 4.3. The Welfare
of society = A + B.
3.

Firm and Profit

A firm is an organization which hires resources to produce output and sell the output to
consumers to make profit. A firm makes profit when its earning from the sales of goods
is more than its cost of production. Thus profit is defined as total revenue less total cost
of production.
Total revenue (TR) is defined as price multiply by quantity sold. Costs are incurred to
acquire resources or input in the production process. A firm may use several resources
and the total cost (TC) is the costs of using all the resources needed in the production.
We assume that the objective of any firm is to maximize profit, firms need to maximize
the difference between total revenue and total cost.
If total revenue exceeds total cost, the firm is making a positive economic profit.
If total revenue equals total cost, the firm is making zero economic profit. However, this
does not mean that the firm is earning zero dollars and cents. It means the firm is earning
the same amount as its next best alternative.
If total revenue is less than total cost, the firm is making a negative economic profit or
incurring a loss. In this case the firm will have to consider shutting down or to continue
operate at a loss.
3.1

Different types of profit

Economists and Accountant have different ways of calculating profit.

(a)

Accounting Profit

Accountant only keep tracks of all payments made to external parties in calculating total
cost : Rental, wages, raw materials, utilities, insurance, taxes etc. Thus when a firm hire
external resources, explicit costs are incurred. Explicit cost includes all payments made
to outsiders for the use of their resources. This includes:
(i)

Rental cost paid to landlord

(ii)

Wages paid to workers

(iii)

Payment to raw materials suppliers

51

(iv)

Miscellaneous cost such as water and electricity bills etc

Accounting profit = Total revenue - Explicit cost

(b)

Economic Profit

Take note that account only considers cost incurred when there is a payment to an
external party. When the firm uses its own resources, there will be no payment involved
and the accountant will consider as no cost is incurred. In contrast, economists considers
cost not only payment to use resources own by external parties but also include cost of
using the firm's own resources. This is the opportunity cost and when the firm uses own
resources, implicit cost (opportunity cost) are incurred.
When an individual set up his own firm, he has to forgo wages earned elsewhere. Thus
there is an opportunity cost incurred and this is an implicit cost.
When the firm uses its own premises for operation, it will have to give up rental it can
earn by renting the premises to an external party, This is also an implicit cost.
Economists include both explicit and implicit cost in calculating total cost
Economic profit = Total revenue - (Explicit cost + Implicit cost)
Thus accounting profit is always larger than economic profit. A firm may be earning
negative economic profit but still earns a positive accounting profit.
(c)

Normal Profit

When total revenue equals total cost, economic profit is zero but accounting profit is
positive.
The firm is earning a profit equivalent to the opportunity cost of its resources. This zero
economic profit is also known as normal profit or break even.
Numerical Example
A person gives up his job of monthly salary $3,000 to set up a company selling shoes.
He converts his house to a shop to sell the shoes. Previously he rented out his house to
collect rental of $1000 per month. He also hires an assistant for $800 per month . The
raw materials, machines, utilities etc cost him $20,000. Within one year, the company
produces 1500 pairs of shoes and they are sold at $30 per pair. How much profit/loss
does he make for the year?

52

Total revenue = $30 X 1,500 = $45,000

Wage cost = $800 X 12 = $9,600
Raw materials and other costs = $20,000
Salary forgone = $3,000 X 12 = $36,000
Rental forgone = $1,000 X 12 = $12,000
Accounting profit = $45,000 - $20,000 - $9,600 = $15,400 (Profit)
Economic profit = $45,000 - $20,000 - $9,600 - $36,000 - $12,000 = -$32,600 (Loss)
3.2

Definitions of Inputs, Short Run and Long Run

Inputs are resources used in the production process. There are two types of inputs, fixed
input and variable input.
Fixed inputs are inputs that cannot be increased within a given period. The fixed inputs
are the building and machines known as capital which the firm normally require a certain
amount of time before they can be acquired and put into the production process.
Variable inputs are inputs that can be increased within a given period. Labour are usually
considered as the variable input and the firm can normally increase the quantity of labour
within a short time frame such as requesting the workers to work overtime.
Short run and long run are different time frame in production process.
Short run refers to the time period which at least one fixed input is used. That is, the time
period is short enough such that firm cannot increase the quantity of at least one of its
inputs. It is assume that capital and land are fixed but labour is variable in the short run.
Thus in the short run, firms can only produce more output by increasing the quantity of
variable inputs to work with a certain fixed inputs.
Long run is the time period where all inputs are variable. That is, the time period is long
enough for firms to build more factories and acquire more machines. Thus in the long
run, firms can increase the quantity of machines and hire more labour to increase output.
The firm will use the long run period to adjust its scale of production and acquire the
optimal amount of labour and capital.
4

Production in the Short Run

In the short run, firms produce more output by using more variable inputs (labour) with
fixed inputs (machines). The production process is subjected to the Law of Diminishing
(Marginal) Returns.

53

4.1

The Law of diminishing returns

The law of diminishing returns states when more and more of labour are being used
together with a fixed amount of capital, eventually the contribution of each additional w
worker to the total output will decline.
Initially with very few workers, each worker has sufficient machines to work with and
thus total output increases by an increasing rate as more workers are used. Eventually
when more and more workers are used, the workers encounter insufficient machines to
work with and their productivity decline. Thus total output increases at a decreasing rate
and may even decline with more workers used.
4.2

Total Product, Average Product and Marginal Product

In the short run where the quantity of capital is fixed, output can be increases only by
increasing labour input. The firm must be adding ever-increasing amounts of labour to a
given amount of plant and machinery. This change in output due to labour input changes
is given by the total product of labour (TP).
The marginal product of labour is the increase in output obtained by adding 1 unit of
labour, holding constant the fixed capital input.
Average product of labour (AP) is defined as Total output divided by total labour.
Table 4.1 shows the relationship between the labour input, the quantity of output and the
marginal product of labour (MP) :
Table 4.1: Total Product, Average Product and Marginal Product
Labour
0
1
2
3
4
5
6
7
8
9
10

Total Product (TP)

0
5
14
30
42
52
58
62
65
66
64

Marginal Product (MP)

5
9
16
12
10
6
4
3
1
-2

Average Product (AP)

5
7
10
10.5
10.4
9.67
8.86
8.13
7.33
6.4

Note that as labour increases, the total product of labour increases but the rate of increase
is declining as more and more labour are added. Eventually total product may even
decrease with more units of labour added.
54

For the marginal product of labour, the first three units of labour experience increasing
marginal product. But from the fourth unit of labour onwards, the marginal product of
labour is declining. Thus there are diminishing returns to labour.
The law of diminishing returns states that holding all factors constant except one, beyond
some level of the variable input, further increases in the variable input lead to a steadily
decreasing marginal product of that input.
4.3

Total Product Curve, Average Product Curve and Marginal Product Curve

Plotting Output versus Labour, the total product of labour curve is derived. A typical
total product curve is shown in Figure 4.4.
Figure 4.4: Total Product Curve
Total Product

TP

Quantity of labour
QL2

QL1

A typical total product curve is a "S" shaped curve. Starting from the origin, initially as
the quantity of labour increases, the workers are able to make better use of the machines
and hence they are very productive. The total product increases at an increasing rate and
it is convex However, after QL1 of labour, the diminishing returns occur and the workers
are becoming less productive. The total product increases at a decreasing rate and the
total product curve becomes concave. After QL2, the productivity of labour becomes
negative and the total product actually decreases with more labour.
Plotting Marginal product of labour and average product of labour versus quantity of
labour, the marginal product of labour curve and the average product of labour curve are
derived. A typical marginal product and average product curve are shown in Figure 4.5.

55

Figure 4.5: Marginal Product and Average Product Curves

Marginal/Average Product

A
AP
MP
Quantity of labour
Both the marginal product and the average product curves are inverted U-shaped curve.
There is an important relationship between the two curves.
Initially when labour are increasing being used in the production process, the increasing
workers are productive and both the marginal product and average product increases.
Thus both curves slope upwards. Eventually as labour increases, diminishing returns
kicks in and both marginal product and average product decrease. Thus both curves
eventually slope downwards.
If the marginal product is higher than average product, the average product will be
increasing. If the marginal product is lower than the average product, the average
product will be decreasing. Thus when the marginal product equals the average product,
it is the maximum of the average product. This is shown at point A of Figure 4.2

4.4

Short Run Total Cost

Since capital is fixed in the short run, the firm can only increase its production by hiring
more variable factors, such as labour. Thus in the short run the firm incurs both fixed
cost and variable cost.
Fixed costs are the costs of hiring fixed factors of production. These fixed costs must be
borne even if output is zero and they do not vary with output levels.
Variable costs are the costs of hiring variable factors of production. The variables are
zero when output is zero and they increases as output increases.
Thus the short run total cost of production (TC) is the sum of the short run total fixed cost
(TFC) and the short run total variable cost (TVC).

56

Table 4.2 shows a typical short run total fixed cost, total variable cost and total cost.
Take note that even when output is 0, total fixed cost is incurred and hence total cost
equals total fixed cost. The total fixed cost remains unchanged as output increases.
However, when output is zero, total variable cost is also zero. As output increases, total
variable cost also increases. Initially because the workers are productive, total variable
cost only increases slowly as output increases. Eventually when diminishing returns
occur, total variable cost will increase rapidly as output increases.
Table 4.2: Total Fixed Cost, Total Variable Cost and Total Cost
Output
0
1
2
3
4
5
6
7
8

4.5

Total Fixed Cost (TFC)

10
10
10
10
10
10
10
10
10

Total Variable Cost (TVC)

0
5
8
10
11
15
20
30
45

Total Cost (TC)

10
15
18
20
21
25
30
40
55

Short run Average Cost and Marginal Cost

We may also divide the total cost by the output level to obtain the average cost. There
are three average cost to consider.
The short run average fixed cost (AFC) equals short run total fixed cost (TFC) divided by
total output.
The short run average variable cost (AVC) equals short run total variable cost (TVC)
divided by total output.
The short run average total cost (ATC) equals short run total cost (TC) divided by total
output, which is also the sum of AFC and AVC.
The short run marginal cost (MC) equals change in total cost divided by change in output.
Since total cost changes is due to changes in total variable cost only, the marginal cost
can also be obtained by change in total variable cost divided by change in output
Table 4.3 shows a typical short run average fixed cost, average variable cost and average
total cost. Take note that average fixed cost is decreasing throughout as output
increases. But for average variable cost, average total cost and marginal cost, they tend
to decreases initially and eventually increases as output increases.

57

Table 4.3: Average Fixed Cost, Average Variable Cost and Average Total Cost
Output
0
1
2
3
4
5
6
7
8
5

TFC
10
10
10
10
10
10
10
10
10

TVC
0
5
8
10
11
15
20
30
45

TC
10
15
18
20
21
25
30
40
55

AFC
10
5
3.33
2.5
2
1.67
1.43
1.25

AVC
5
4
3.33
2.75
3
3.33
4.29
5.63

ATC
15
9
6.67
5.25
5
5
5.71
6.88

MC
5
3
2
1
4
5
10
15

Cost Curves

Plotting the cost of production versus quantity of output, we have the cost curves. It is
important to recognize the share of the various cost curves and the relationship between
the cost curves.
The TFC, TVC and TC curves are plotted in Figure 4.6.
Figure 4.6: Various Short Run Total Cost Curves
Cost

TC

TVC

TFC

Quantity of output
The TFC curve is a horizontal staright line at the fixed cost level, since fixed cost does
not change with output. The TVC curve increases as output incraeses but is is an inverse
"S" shaped curve, consists of an initial concave portion and eventually a convex portion
as output increases. The TC curve follows the shape of the TVC curve and it is

58

vertucally above the TVC curve by the amount of the fixed cost. Thus the vertical gap
between TVC and TVC is TFC for each output level.
The ATC, AVC and MC curves are plotted in Figure 4.7. The three curves are all Ushaped curves and there are important relationship between the three cost curves.
Figure 4.7: Various Short Run Average and Marginal Cost Curves
Cost

MC
ATC
AVC
B

Quantity of output

Note that ATC curve is always above AVC curve but the gap decreases as output
increases. This is because the gap between ATC curve and AVC curve is AFC and AFC
decreases as output increases.
Initially as output increases, the workers are productive and hence MC is decreasing and
MC curve is downward sloping. Eventually when the workers are less productive due to
diminishing returns, MC will be increasing and MC curve will be upward sloping.
If MC is less than AVC, AVC is decreasing. If MC is higher than AVC, AVC is
increasing. Thus when MC equals AVC, it is the minimum of AVC. This is shown in
point A of Figure 4.3.
Likewise if MC is less than ATC, ATC is decreasing. If MC is higher than ATC, ATC is
increasing. Thus when MC equals ATC, it is the minimum of ATC. This is shown in
point B of Figure 4.3.
Thus another feature of the curves is that MC curve cuts through the lowest point of AVC
curve and ATC curve from below.

59

Production in the Long Run

In the long run, all inputs are variable. Assume that a firm increases all its inputs by the
same proportion. There are three possible outcomes.
Increasing returns to scale (or economies of scale) occurs when output increases by a
larger proportion than inputs increase. This could be due to specialisation and division of
labour, indivisibilities, greater efficiency of large machines, organisational economies,
spreading overheads, financial economies etc. This will result in a decreasing long run
average total cost as output increases.
Decreasing returns to scale (or diseconomies of scale) occurs when output increases by a
smaller proportion than inputs increase. This could be due to management problems of
co-ordination increase as firms become large, workers feel alienated, deteriorate
industrial relations and disruption in complicated mass production processes. This will
result in an increasing long run average total cost as output increases.
Constant returns to scale (or constant costs) occurs when output increases by the same
proportion as inputs increase. This could be due to the forces of increasing returns to
scale just offset the forces of decreasing returns to scale. This will result in a constant
long run average total cost as output increases.
In a typical firm in the long run, as output increases, it is likely that a firm will experience
increasing returns to scale, follow by constant returns to scale and eventually increasing
returns to scale as output increases. Thus the long run average total cost (LRATC) curve
of a firm is also U-shaped. This is shown in Figure 4.8.
Figure 4.8: Long Run Average Total Cost Curves
Cost

LRATC

Increasing
returns to
scale

Constant
returns to
scale

Decreasing
returns to
scale
Quantity of output

60

Economies of scale (or increasing returns to scale) occurs when long run average costs
decrease as output rises. It occurs mainly due to spreading of high fixed cost over more
units of output as output is increased, division of labour resulting in each worker can
become more efficient by concentrate on fewer tasks and justification of using
sophisticated machinery and advance technology in production.
Diseconomies of scale (or decreasing returns to scale) occurs when long run average
costs increase as output rises. It occurs mainly due to managerial diseconomies of scale.
This arises because management becomes more difficult as the firm becomes larger.
Large company need many layers of management, lead to communication, control and
coordination problems.
7.

Discussion Questions

Question 1
Given that the accounting profit of a firm is $28,000, we can conclude that
(a) the economic profit must be more than $28,000
(b) the economic profit must be $28,000
(c) the economic profit must be less than $28,000
(d) the economic profit can be more than, equal to or less than $28,000
Question 2
Given that the total product of 4 workers is 6 units and that of 6 workers is 18 units, the
marginal product is
(a) 6 units
(b) 12 units
(c) 18 units
(d) 24 units
Question 3
The total variable cost (TVC) of 4 units of output is $20 and that of 8 units of output is
$65, the marginal cost is
(a) $11.25
(b) $45
(c) $65
(d) Unable to determine since total cost (TC) is not given

61

Question 4
As output increases, which of the following statement is correct?
(a) Total fixed cost must increase
(b) Average total cost must increase
(c) Average fixed cost must decrease
(d) Marginal cost must increase
Question 5
If a production process exhibits diseconomies of scale throughout, then the long run
average cost curve is
(a) horizontal
(b) upward sloping
(c) downward sloping
(d) U-shaped
Question 6
Use the following formulae to complete the table in the next page
TC = TFC + TVC
MC = Change in TC/Change in Output
AFC = TFC/Q
AVC = TVC/Q
ATC = TC/Q = AFC + AVC
Q
0
1
2
3
4
5
6
7
8

TFC
20

TVC
0
6
10
12
18
28
40
55
76

TC

AFC

62

AVC

ATC

MC

Question 7
Consider a firm producing computers using both machines and labour.
(a)
In the short run, the quantity of machine is fixed. What will happen to the firms
total product and marginal product when more labour is employed? In this process,
explain the law of diminishing (marginal) returns.
(b)
Explain the shape of the short run average total cost curve and the short run
marginal cost curve. What is the relationship between the two curves?
(c)
In the long run where both machines and labour are variable, the firms average
cost curve follows a U-shaped. Use the concept of returns to scale to explain the shape of
the firms long run average cost curve.

63

ELEMENTS OF ECONOMICS
SESSION 5
PERFECT COMPETITION
At the end of the session, students should be able to:
1.
Discuss the characteristics of a perfectly competitive industry
2.
Discuss the characteristics of a perfectly competitive firm
3.
Explain a perfectly competitive firms profit-maximising choices.
4.
Explain how output, price, and profit are determined in a perfectly competitive firm
5.
Explain the short run equilibrium of a perfectly competitive firm.
6.
Explain the long run equilibrium of a perfectly competitive firm.
___________________________________________________________________
1.

Introduction

In this session, we begin with an introduction to the framework of perfect competition.

Next, we analyse the short run equilibrium of perfect competition. Then we introduce the
long run equilibrium of perfect competition.
The market structure is a description of the behaviour of buyers and sellers in that market.
There are two different market structures in this module : Perfect competition and
monopoly. In this session we discuss perfect competition while in Session 6 we analyze
monopoly.
2.

Perfectly Competitive Market and Firm

2.1

Assumptions of Perfect Competition

A perfectly competitive market is one in which both buyers and sellers believe that their
own buying or selling decisions have no effect on the market price. It is built with the
following assumptions:
(1)
A large number of buyers and sellers. So each seller has only a very small market
share and each buyer only purchase a very small quantity of the total output.
(2)
Homogeneous product. Each firm sells exactly the same product. It makes no
difference whether the consumer purchase from one firm or the other.
(3)
Free entry and exit for firms. There is no obstacle to prevent new firms to enter
the industry to compete with existing firms. It is also very easy for existing firms to leave
the industry.

64

(4)
Perfect information. All buyers and sellers have all the information regarding the
price, quantity and quality for the product.
(5)
Perfect mobility of factors. All the factors of production can move from one use
to another use without any restrictions.
2.2

Characteristics of Perfectly Competitive Firm

Due to the 5 assumptions of a perfectly competitive market, all firms are price takers in
the market. The industry demand and supply forces determine the equilibrium price and
all firms take this price as given. All firms and customers are price takers and that there
will be a single price in the market.
They cannot charge higher price, will not charge lower price and can sell off all their
output at this price. Thus each firm has a horizontal demand curve. The demand curve is
also the average revenue curve and marginal revenue curve since price is fixed.
With many customers in the industry and each firm only has a very small market share,
the firms can sell whatever quantity they wish. Likewise the customers are also able to
buy whatever quantity they wish. No single customer and single firm is able to influence
the market price.
The market price is determined jointly by al the buyers and sellers in the market, as
shown in Figure 5.1 panel (a). Once this price is established, the firms will have to take
this price as given to them. Thus there is only one single price in the market and each
firm can only sell all its output at this price. Each competitive firm has a horizontal
demand curve, as shown in Figure 5.1 panel (b).
Figure 5.1: Perfectly Competitive Market and Firm
(a) Market

(b) Firm

Price

Price
S

P*

P*

d = MR

D
Quantity
Q*

65

Quantity

In the above diagram, the marker demand curve is downward sloping and market supply
curve is upward sloping, following the law of demand and supply. The equilibrium price
P* is determined by the intersection of demand and supply curve.
Once this price is determined, each firm charge the same price P* per unit for all
quantities of their product. Since the firm can sell whatever quantity they wish at that
price, the demand is a horizontal line, which is perfectly elastic.
The firm will have no incentive to charge a price lower than P* since it can sell all it
wishes at price P*. It cannot charge a price higher than P* since the customers can
purchases from the other firms. Thus there is only a single price.
Since the price is fixed, for every unit that the firm sells, it will earn additional revenue
equals to the price. The additional revenue from selling one more unit of output is the
marginal revenue (MR). Thus for a perfectly competitive firm, the firm's demand curve
is also its marginal revenue curve which is the same as the market equilibrium price.
3

Short Run Equilibrium

In the short run, a perfectly competitive firm will have to decide based on the given
market price, should produce or shut down. If it chose to produce, then the firm will have
obtain the resources to initiate the production. Since price is determined by market forces
and each firm is a price taker, each firm will have to decide on the quantity of output
produced in the short run and sell all its output at this price. The optimal output is one
that maximizes the firms profit or minimizes its loss.
3.1

Optimal output

For every additional unit of output that the perfectly competitive firm sells in the market,
the additional revenue earned is the marginal revenue (MR) is the same as the market
equilibrium price.
For every additional unit of output that the perfectly competitive firm produces, it will
incur an additional cost which is the marginal cost (MC).
If MR is greater than MC, the firm will earn more profit by producing more output. If
MR is less than MC, the firm will earn more profit by producing less output. Thus the
optimum output is given by the level where marginal revenue equals marginal cost. This
is shown in the output q* in Figure 5.2

66

Figure 5.2: Optimal Output of a Perfectly Competitive Firm

Cost
MC

MR

Output
q*
In general, firm uses the marginal condition (MC = MR) to find the best output and then
use average condition to check whether the price can cover the average cost. But in
perfect competition, price equals marginal revenue (MR) and the firms demand curve is
also the marginal revenue curve. Hence the optimal output condition becomes MC = P.
3.2

Firms Short Run Profit Situation

Although a perfectly competitive firm's optimal output is at the level where MR = MC,
the firm may be maximizing its profit or minimizing its loss at this output or break even.
It all depend on whether at the optimal output the price is higher, equal or less than the
short run average total cost.
Thus in the short run, at the output level where MR = MC, the firm will make profits if
price exceeds Average total cost (ATC). The firm will break even if price = ATC and the
firm will incur losses if price is less than ATC.
(a)

Positive economic profit

Figure 5.2 shows a perfectly competitive firm making positive economic profit. The
optimal output is given by the point A where MR intersects MC. The optimal output is
q1. At this output, the firm is making profit since the price is higher than the average total
cost. The maximum profit is represented by the area bounded byP1, A, B and ATC1.

67

Figure 5.2: Profit Making Perfectly Competitive Firm

Cost

MC
ATC

P1

ATC1

MR1

Output
q1
(b)

Break even or normal profit

Figure 5.2 shows a perfectly competitive firm making positive economic profit. The
optimal output is given by the point where MR intersects MC. This is shown in point C
of Figure 5.3 and the optimal output is q1. At this output, the firm breaks even because
the price is the same as the average total cost.
Figure 5.3: Perfectly Competitive Firm Making Normal Profit
Cost

MC

ATC

C
P2 = ATC2

MR2

Output
q2

68

(c)

Negative economic profit or loss

Figure 5.4 shows a perfectly competitive firm making positive economic profit. The MR
curve is below the ATC curve at the optimal output level where MR = MC. This is
shown at point E where the optimal output is q3. At this output the firm is incurring a
loss since the price is less than the average total cost. The loss is equal to the area
bounded by ATC3, P3, E and D.
Figure 5.4: Loss Incurring Perfectly Competitive Firm
Cost

MC
ATC

D
ATC3
E
P3

MR3

Output
q3

3.3

Shut Down Condition of Perfectly Competitive Firm

In the short run, a loss incurring perfectly competitive firm has to decide whether to
continue to operate at a loss or to shut down. Note that shut down means temporary
closed the firm waiting for better time to operate. This is different from exit the industry
which means closed down the firm permanently.
The loss incurring firm will choose the best option, which is the option that minimizes the
loss. Since the firm already purchased the capital, whether the firm operate or shut down
the fixed cost is already incurred. Assume that there is no resale value for the capital.
If the firm were to shut down, there will be no output produced and the firm will not
require any variable inputs. Thus the total variable cost is zero and the total cost is just
its total fixed cost. In addition, since the firm did not produce any output, the total
revenue is also zero. using the formula profit = total revenue minus total cost, the firm's
loss is equivalent to its fixed cost.

69

If the firm were to operate, it will need to employ the variable resources and the total
variable cost will be positive. Thus total cost will be the sum of total fixed cost and total
variable cost. When the firm sells its output, the firm will earn positive total revenue.
However, the total revenue will be less than the total cost since the firm is incurring a
loss.
Compare the two situations, the loss will be smaller if total revenue is larger than total
variable cost. This is because if the total revenue is larger than the total variable cost, the
firm will not only cover all its variable cost but also has some balance to cover part of its
fixed cost. Thus the loss will be less than the total fixed cost.
In contrast, if the total revenue is smaller than the total variable cost, the firm will lose
part of its variable costs and also all its fixed cost. Thus the loss will be larger than the
total fixed cost and it will be better for the firm to shut down.
If the total revenue is the same as the total variable cost, there will be no different
whether the firm shut down or operate as the loss will be the same. This is known as the
shut down condition of the firm in the short run. It can also be expressed as price equals
average variable cost.
4

Long Run Equilibrium in Perfect Competition

In the long run, all factors of production are variable. If the firms are making
supernormal profit in the short run, this will attracts more new firms to enter the industry.
If the firms are incurring losses, some firms may leave the industry.
(1)

Adjustment From Short Run Profit Situation

In the short run, if existing competitive firms are making positive economic profit, this
will attract new firms to enter the industry. Since there is free entry and exit, it is easy for
new firms to gain entry into the industry and compete with the existing firms.
With more new firms, the market supply increase. This is shown in a rightward shift of
the supply curve. This shift will push down the equilibrium price and increasing the
equilibrium quantity in the market.
From the firm's point, when market price reduces, the firm's MR curve also shift
downwards. It will intersect the MC curve at a lower output level, and the gap between
price and average total cost becomes smaller. Thus the profit of the existing firms will
reduce.
New firms will continue to enter the industry so long there is profit to make. They will
only stop entering the industry when all existing firms are making normal profit. The
process is described in Figure 5.5.

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Figure 5.5: Long Run Adjustment of Profit Making Firm

(a) Industry
Price
P1
P2

(b) Firm
S2

S1

Price
MC

E1

ATC
E2

P1

d1 = MR1

P2

d2 = MR2

D
Quantity
Q1 Q2

q2 q1

Quantity

Initially the market is at equilibrium at E1 with price P1. The firm will produce at the
output level where MR = MC which is q1. At this output, since price is higher than
average total cost, the firm is making a positive economic profit.
In the long run, new firms are attracted by the profit to enter the industry. This will
increase the industry supply and decrease the price until the new equilibrium price at P2
where all firms produce a lower output q2 and break even.
(2)

Adjustment From Short Run Loss Situation

In the short run if existing firms are making losses, then the industry becomes
unattractive and firms may contemplating exiting the industry in the long run.
Firms may have different level of pessimism when encounter losses. Those firms that are
more pessimistic may exit at the first sign of losses. Firms that are more optimistic may
decide to ensure for a longer period of time, hoping that market condition will improve.
This give rises to some firms leave while other firms stay in the industry.
With some firms leaving the industry, the industry supply will decrease. This will shigt
the supply curve to the left, pushing up the market price and reducing the market
equilibrium quantity. At the firm's level, when market price increases, the marginal
revenue also increase and the firm will produce more output. Then gap between the
market price and average total cost becomes smaller, hence the loss of existing firms also
reduces. More existing firms will continue to leave the industry so long there is loss
incurred until the price rise enough for those who remain to cover all their costs. The exit
of firms will only cease when all existing firms are making normal profit. Thus in the
long run all competitive firm can only make normal profit. The process is described in
Figure 5.6.

71

Figure 5.6: Long Run Adjustment of Loss Incurring Firm

(a) Industry
Price
P2
P1

(b) Firm
S1

S2

Price
MC

E2
E1

ATC

P2

d2 = MR2

P1

d1 = MR1

D
Quantity
Q2 Q1

q1 q2

Quantity

Initially the market is at equilibrium at E1 with price P1. The firm will produce at the
output level where MR = MC which is q1. At this output, since price is lower than
average total cost, the firm is incurring a loss.
In the long run, some firms that cannot withstand the loss further will leave the industry.
This will reduce industry supply until the new equilibrium price at P2 where all firms
produce a higher output q2 and break even.

72

5.

Discussion Questions

Question 1
What will happen if the market equilibrium price is $5 and a perfectly competitive firm
charges $6 for its product?
(a)
(b)
(c)
(d)

The firm will still earn some revenue

The firm's revenue will be zero
The firm will maximize its profit
The firm should produce less since it charges a higher price than the market.

Question 2
Which of the following regarding a perfectly competitive firm s correct given that the
market price of the product is $8?
(a)
(b)
(c)
(d)

The firm should charge less but not more than $8 to maximize profit.
The optimal output occurs at the level where marginal cost is more than $8
The optimal output occurs at the level where marginal cost is less than $8
If the firm sells 5 units, it will earn $40.

Question 3
Given that in a perfectly competitive market, the market price is $6 and the firm's
marginal cost at the current output is $8, the firm should
(a)
(b)
(c)
(d)

produce more output

maintain its current output since it is profit maximizing
produce less output
increase the price to $8

Question 4
In the short run if all perfectly competitive firm are making profit, then in the long run
(a)
(b)
(c)
(d)

some firms will leave the industry

the firms will continue to make profit
new firms will enter the industry
the market price will increase

73

Question 5
In the long run, if a perfectly competitive firm is incurring a loss,
(a)
(b)
(c)
(d)

it should continue to operate at a loss, hoping that situation will improve

it should exit the industry
it should reduce its output to cut its loss
it should charge a higher price to cut its loss

Question 6
Explain with suitable diagrams the adjustment from a short run profit making equilibrium
to a long run equilibrium in a perfectly competitive firm.
Question 7
Explain with suitable diagrams the adjustment from a short run loss incurring equilibrium
to a long run equilibrium in a perfectly competitive firm.

74

ELEMENTS OF ECONOMICS
SESSION 6
MONOPOLY
At the end of the session, students should be able to:
1.
Define monopoly
2.
Explain how monopoly arises
3.
Distinguish between single-price monopoly and price-discriminating monopoly.
4.
Explain how a single-price monopoly determines its output and price.
5.
Compare the performance of a single-priced monopoly with perfect competition
_______________________________________________________________________
1.

Introduction

In this lecture, we begin with an introduction to the framework of monopoly. Next we

analyse the profit maximization situation of a single priced monopoly. Then we
introduce the concept of a price discriminating monopoly. Finally, we make a
comparison between perfect competition and monopoly focusing on their efficiency.
2.

Monopoly

A monopolist is the only supplier of a product in the market and the product has no close
substitutes. The reason why only one firm exists in the market is due to extensive
barriers of entry which make new firms difficult to enter the industry. Even in the long
run new firms are not allowed to enter the industry.
Since there is only one firm in the industry, customers who want to buy the product in the
market can only get it from this firm. Thus the firms demand curve is also the markets
demand curve. Unlike perfect competition which the firm is a price taker, a monopolist
has the ability to influence the market price and is a price setter.
2.1

Barriers to Entry

For a monopoly to exist there must be substantial barriers to entry of new firms. With the
barriers to entry, if in the short run the monopolist makes an economic profit, it can
continue to make this profit in the long run.
The barriers to entry could be due to the following reasons:
(a)
Economies of scale: The larger the output, the lower the average total cost of
production such that the industry can only be efficiently supported by one producer. This
75

is known as natural monopoly and the long run average total cost curve is downward
sloping throughout, as shown in Figure 6.1.
Figure 6.1: A Natural Monopoly
Cost

P2 = ATC2

P1 = ATC1

A
ATC
Output
Q1

Q2

In Figure 6.1, the incumbent firm has a large customer base and produce a large quantity
Q1 with a low average total cost ATC1. Thus the incumbent form can charge a price P1
and still break even. However, for a new comer with a smaller customer base, the new
firm may only produce a small output Q2 which has a higher average total cost ATC2.
Thus the new firm must charge a price P2 just to break even. The incumbent can charge
any price higher than P1 and lower than P2 to drive the new firm out of the market.
Hence the first firm that enters the industry has the ability to capture the entire market
with large scale production with lower average total cost. Any new firm that enters the
industry bound to start with a small scale of production that results in higher average total
cost, thus unable to compete with the incumbent firm. Hence there is only one firm in the
entire market.
Besides the cost advantage, the first firm that enter the market may also be able to
cultivate customer's loyalty such that consumers will prefer its product rather than the
newcomer's unknown product.
(b)
Control of key inputs: To produce products, resources are needed and some
resources could be scarce. If a firm controls the supply of important resources needed to
produce a product, it may become a monopoly because other firms may not be able to
obtain the resource to produce the same product.

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(c)
Most of the monopolists are created due to legal protection. This could be in the
form licences granted by the government in order to produce the product or service. If
the government only grants one licence in the entire country, then there will only one
seller for the entire market. Another type of legal protection is the patent and copyright.
If the inventor has a patent of the technology to produce a certain product, then other
firms are unable to use the technology to produce the same product.
2.3

Demand Curve and Marginal Revenue Curve

Although the monopolist has the ability to set price, it is unable to set any price it desires
as consumers must still be willing and able to pay for the product. The firm is still
subjected to the law of demand when selling its product.
A single price monopolist is one that charge the same price to all its customers, regardless
of the quantity purchased by the customers. Thus if the monopolist sets a high price, less
consumers will buy its product. If the monopolist sets a low price, more customers will
buy its product. This implies that a monopolists demand curve is downward sloping. In
contrast, a perfectly competitive firm's demand curve is horizontal and the firm can sell
all its product at the current market price which is determined by the market demand and
supply curve.
Consider a single price monopolist which initially sells a small quantity of its output at a
high price, if the monopolist wishes to sell more output, it will have to lower the price,
not just for the additional output but also the previous output.
For example, assume that a monopolist is selling 3 units of output at $6 per unit, earning
a total revenue of $3 X 6 = $18. If the monopolist wishes to sell 4 units of output, it will
have to lower the price to $5 per unit. This $5 applies to not just the additional unit (the
4th unit) but also the previous 3 units. So the new total revenue is $5 X 4 = $20. The
additional revenue from selling one more unit, which is the marginal revenue, is only $2
even though the firm sells one more unit at $5.
Although the 4th unit allows the monopolist to earn an additional revenue of $5 which is
equal to the price, the monopolist will have to earn less revenue from the first 3 units
which it must also sell at $5 instead of $6 previously. Thus the marginal revenue is $5
from the 4th unit minus $3 from the first 3 units, which is $2 and less than the price.
Table 6.1 shows a the price, quantity, total revenue and marginal revenue of a typical
monopolist. Take note that the marginal revenue is always less than the price.

77

Table 6.1: A Single-Price Monopolist Price and Marginal Revenue

Quantity
0
1
2
3
4
5

Price
10
9
8
7
6
5

Total Revenue
0
9
16
21
24
25

Marginal Revenue
9
7
5
3
1

Figure 6,2 shows the demand curve and the marginal revenue curve of a single price
monopolist. Both are downward sloping but the marginal revenue curve lies below the
demand curve since price is higher than marginal revenue. For example, at the output Q1,
the price given by the demand curve is P1 while the MR given by the MR curve is MR1
which is lower than P1.
Figure 6.2: Demand Curve and Marginal revenue Curve
Price

P1
MR1
Demand curve
MR curve
Output
Q1
In general, if both the demand curve and marginal revenue curve are straight lines, the
marginal revenue curve will share the same Y-intercept and has twice the slope of the
demand curve.
3

Determination of Price and Output

The objective of a monopolist is to maximize profit. Similar to a perfectly competitive

firm, the monopolist will have to determine the optimal output using the marginal
analysis. An additional unit of output will bring the additional revenue (marginal
revenue) to the monopolist but it also incurs additional cost (marginal cost) to the
monopolist since more resources are needed.

78

If MR exceeds MC, the monopolist will earn more profit by producing one more unit of
output. If MR is less than MC, the additional unit of output will create a loss to the
monopolist. Hence the monopolists optimal output is the level where MR = MC. This
is shown in Figure 6.3 where the optimal output is Q*. To clear all the output, the
monopolist will need to charge the price P* based on the demand curve.
Figure 6.3: Optimal Output of a Single Priced Monopolist
Cost
MC

P*
D

MR

Output

Q*
3.1

Profit and Loss For a monopolist

The optimal output for a monopolist is at the level where MR equals MC. But at this
output level, the monopolist may be making profit or incurring loss. Just because a firm
is a monopolist will not guarantee that it always make a profit. It depends on the value of
price and average total cost at this output level.
If the price is higher than average total cost, the monopolist will be making a profit. The
monopolist will incur losses if its price is lower than the average total cost at its optimal
output. If the price equals the average total cost, the monopolist will break even.

79

Figure 6.4: Profit Making Single Priced Monopolist

Cost

MC

ATC
P1

A
B

ATC1

D
MR

Output

Q1
Figure 6.4 shows a profit making monopolist. Setting MR = MC, the monopolist
produces at output Q1. From the demand curve, the monopolist will set the price at P1,
knowing that at this price the consumer will demand for Q1 units of output. Thus the
amount of profit earned is (P1 - AC1) X Q1. This is shown by the rectangle bounded by
P1, A, B and ATC1. Note that at this output, price exceeds marginal cost. The excess of
price over marginal cost is a measure of monopoly power.
In the long run, since there is no possibility of entry, the monopolist can continue to make
this profit. But a loss incurring monopolist will leave the industry in the long run.
4

Price Discrimination

Although a single price monopolist maximizes its profit if price exceeds average total
cost at the output level where MR =MC, its profit can be higher if it practices price
discrimination.
Price discrimination means the monopolists either charge different price to different
customers for the same product produced with the same cost, or charge different prices to
different quantity of output purchased by the customers where the cost is the same.

80

4.1

Conditions of Price Discrimination

To practise price discrimination, the firm must be able to set its price, the markets for
different customers must be separated and the demand elasticity must differ in each
market.
4.2

Types of Price Discrimination

First-degree price discrimination occurs where the firm charges each consumer the
maximum price he is prepared to pay for each unit. This is also known as perfect price
discrimination.
Second-degree price discrimination occurs where the firm charges customers different
prices according to how much they purchase. This is also called batch price
discrimination.
Third-degree price discrimination occurs where consumers are grouped into different
markets and a separate price is charged in each market.

Efficiency and Market Structure

It is widely believed that competition enhances efficiency but monopoly breeds

inefficiency. Thus perfect competition is efficient but monopoly is inefficient.
5.1

Types of efficiency

There are two types of efficiency: Productive and allocative efficiency.

Productive efficiency refers to the situation where a firm uses the most efficient method
to produce its output. This means the firm can produce the maximum amount of output
with a given amount of inputs. It is generally reflected at producing at the lowest point of
the long run average total cost curve.
Allocative efficiency refers to the situation where the output are being produced and
distributed to the consumers in such a way that that maximizes their satisfaction when
consuming the product. This requires the utilizing resources in production and charging a
price such that it maximizes the welfare of the society. It is generally reflected at the
output level where price equals marginal cost.

81

5.2

Perfect Competition and Efficiency

In perfect competition, the industry demand and supply forces determine the price and
quantity and every firm takes this price as given and produce at the output level where
price equals marginal cost. All the firms output adds up to form the market output
supplied and the demand for all the firm's output add up to form the market output
demanded. Thus perfect competition always ensure that the market produce at the point
where industry demand curve intersects the industry supply curve.
In the long run, all firms break even. Thus at the optimal output level where MR = MC,
the condition P = ATC is also fulfilled. There is productive efficiency because the firms
produce at the lowest point of average total cost, which is q1 where the MC curve
intersects the ATC curve.. There is allocative efficiency because at the optimal output,
price equals marginal cost. This is shown in Figure 6.5.
Figure 6.5: Perfect Competition and Efficiency
Cost

MC
ATC

d = MR
P1 = ATC1=MC1

Output
q1

5.3

Monopoly and Inefficiency

Under perfect competition, there is efficiency and the welfare of the society will be
maximized. But when competition is imperfect, there will be inefficiency and
deadweight loss will occur. When competition is imperfect, resources will not be used in
the most efficient manner. There will be productive inefficiency as well as allocative
inefficiency. This is shown in the case of a single priced monopolist.

82

In a single priced monopolist, the demand curve is always above the marginal revenue
curve. The monopolist will produce at the output level where marginal revenue equals
marginal cost and charge a price at this output level based on the demand curve.
Consider a single priced monopolist making profit in the long run. this is shown in
Figure 6.6.
Figure 6.6: Single Priced Monopolist and Inefficiency
Cost

MC

ATC
P1
B
MC1

D
MR

Output

Q 1 Q2
In Figure 6.6, the optimal output of a monopolist is at the level where MR equals MC
which is Q1. At this output level, there is productive inefficiency since the monopolist
did not produce at the lowest point of average total cost curve which is at output Q2.
There is allocative inefficiency since at the output level the price (P1) is higher than the
marginal cost (MC1). Consumers pay a much higher price and get fewer outputs due to
the market power of a monopolist.
However, a monopoly may have the advantage over perfect competition if it is a natural
monopoly. The monopolist will have a large customer base and produce at a large output
with lower average cost. The monopolist can thus afford to charge a lower price which
benefits the consumers. Also the possibility of long term profit may induce the
monopolist to implement research and development effort to introduce new and better
products which benefit the society.
5

Comparing between Perfect Competition and Monopoly

We have mentioned in Section 4 that perfect competition is both productive and

allocative efficient, while a single-priced monopolist is both productive and allocative
inefficient. From the society point of view, we can also conclude that perfect competition

83

maximizes social welfare while monopolist creates deadweight loss and is socially
inefficient.
Consider the market of a product. Assume that the benefits received by the society arises
from the consumers that consume the product while the cost incurred by the society arises
from the producers that produce the product. The demand curve is therefore the marginal
social benefit curve while the supply curve is the marginal social cost curve. The society
will maximizes its welfare at the output level where marginal social benefit equals
marginal social cost.
In a perfectly competitive market, the price and quantity are determined by the demand
and supply curves. The long run equilibrium price and quantity are obtained from the
intersection point of the market demand and supply curve. This is the same as the level
where marginal social benefit equals marginal social cost. Thus perfect competition
maximizes social welfare. This is shown in Figure 6.7. The price under perfect
competition is PC and the quantity under perfect competition is QC.
In contrast, a profit making single priced monopolist optimizes at the output level where
MR = MC. Since the MC curve is the same as the market supply curve and the MR
curve is always below the market demand curve, this output level will be less than the
market equilibrium output under perfect competition. With a downward sloping demand
curve, the monopolist will also charge a higher price than perfect competition. This is
shown in Figure 6.7. The price under monopoly is PM and the quantity under monopoly
is QM.
Figure 6.7: Price and Output under Perfect Competition and Monopoly
Price

S = MC
PM
PC

MR
Q M QC

D
Output

Recall that producer surplus is the area under market price and above the supply curve,
while consumer surplus is the area under the demand curve and above the market price.

84

Figure 6.8 compares the social welfare under perfect competition with monopoly. Under
perfect competition, the producer surplus is given by the area BCPC, while the consumer
surplus is given by the area ACPC. The social welfare is given by the sum of producer
and consumer surplus which is the area ABC.
Under a single priced monopolist, the producer surplus is given by the area PMDEB,
while the consumer surplus is given by the area ADPM. The social welfare is given by
the sum of producer and consumer surplus which is the area ADEB. The monopolist
results in a higher producer surplus and a lower consumer surplus but overall there is a
net welfare loss due to the deadweight loss represented by the area CDE.
Figure 6.8: Social Welfare under Perfect Competition and Monopoly
Price
A
S = MC
D
PM
PC

C
E

B
MR
Q M QC

D
Output

Table 6.2 summarizes the comparison among perfect competition and monopoly.
Table 6.2: Comparison between Perfect Competition and Monopoly
Number of Sellers
Nature of Products
Barriers to entry
Long run profit
Firm's Demand Curve
Relationship between price
and marginal revenue
Efficiency

Perfect Competition
Many
Identical
None
Normal
Horizontal
Price equals marginal
revenue
Efficient

85

Monopoly
One
No close substitutes
Substantial
Can be positive
Downward slopping
Price is larger than marginal
revenue
Inefficient

The differences can be expressed in terms of number of sellers, nature of products,

barriers to entry, long run profit, firm's demand curve, relationship between price and
marginal revenue and efficiency.
6.

Discussion Questions

Question 1
The difference between perfect competition and monopolist is that for perfect
competition, price ______ marginal revenue and for monopolist, price ______ marginal
revenue.
(a)
(b)
(c)
(d)

is higher than , is lower than

is lower than , is higher than
is higher than, is equal to
is equal to, is higher than

Question 2
If at the output level where MR = MC, the monopolist is producing 20 units of output,
charging a price of $6 and incur an average total cost of $4, the monopolist is making
________ of _________.
(a)
(b)
(c)
(d)

profit, $80
loss, $80
profit, $20
loss, $20

Question 3
For a single priced monopolist, if at the current level of output its marginal cost is $8
while its marginal revenue is $6, we can conclude that
(a)
(b)
(c)
(d)

the monopolist is maximizing its profit.

the monopolist should produce more to maximize its profit.
the monopolist should produce less to maximize its profit.
the monopolist needs to charge a lower price to maximize its profit.

86

Question 4
Which of the following statement regarding price discriminating monopolist is correct?
(a)
(b)
(c)
(d)

A price discriminating monopolist will produce less than a single price

monopolist.
A price discriminating monopolist will earn a lower profit than a single price
monopolist.
A price discriminating monopolist will earn a higher profit than a single price
monopolist.
A perfect price discriminating monopolist is socially inefficient.

Question 5
Compared to perfect competition, a monopolist will charge a ______ price and produce a
________ output.
(a)
(b)
(c)
(d)

higher, higher
higher, lower
lower, higher
higher, higher

Question 6
Explain with a diagram how the optimum output and the price of a single priced
monopolist are determined.
Question 7
(a)
Explain with a suitable diagram why perfect competition is socially efficient but
monopoly is socially inefficient.
(b)

Are there any advantages of having monopoly in a market?

87

ELEMENTS OF ECONOMICS
SESSION 7
FUNDAMENTAL OF MACROECONOMICS
At the end of the session, students should be able to:
1.
Define GDP
2.
Explain how GDP is measured.
3.
Distinguish between nominal GDP and real GDP.
4.
Explain the limitations of GDP in indicating standard of living.
5.
Define recession
6.
Explain the formation of business cycle
________________________________________________________________________
1.

Introduction

In this session, we begin with a discussion and definition of the term macroeconomics.
Next we define gross domestic product and explain the method in measuring gross
domestic product. We then distinguish between nominal GDP and real GDP and discuss
the limitations of GDP in indicating standard of living. Finally we discuss the formation
of business cycle and discuss the occurrence of expansion and recession.
2

Macroeconomics

Macroeconomics concerns the overall performance of the economy. In an economy,

there are many firms and consumers and the government may also perform certain
functions that affect the economy. An economy may also interacts with the rest of the
world through international trade and investment. Thus macroeconomics considers the
interaction of all these economic agents together. The focus of macroeconomics is the
performance of the economy and we are interested in issues such as the amount of output
produced, the general price of goods and services and the extent of people who are
unemployed in the economy.
2.1

Gross Domestic Product

In macroeconomics, we are interested in measuring the performance of the economy.

The performance of an economy is usually measured by the total value of output
produced in a country, known as the gross domestic product (GDP).
Over the years, if the current year GDP is higher than the previous year GDP, then there
is an economic growth and the percentage change in the GDP is known as the economic
growth rate.

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GDP can also be used to compare across countries. A country that has a higher GDP is
deemed to have good performance compared to another country that has a lower GDP.
2.1

Definition of Gross Domestic Product

The gross domestic product of an economy is the market value of the final output
produced in the country within a certain timeframe.
There are four important elements when analyzing the GDP of an economy:
(a)

Market value

First, GDP only measures the market value of output. This means only those goods and
services that are transacted through the market will be recorded in the economy's GDP.
If a firm produces food and sells the food in the market to customers, the value of the
food will be included in the GDP. But if a household produce food and services for its
members to consume, the value of the food will not be included in the GDP since the
output did not go through the market system. In addition, there are many goods and
services produced by individuals and sell directly to their customers without going
through the market system. These are called underground economy and the values of
output produced by the underground economy is not included in the calculation of GDP.
(b)

Final output

In a typical economy, there are many firms producing many different types of output and
it is common that some firms purchase the other firm's output as inputs in its own
production. If the output of Firm A is used as an input in Firm B and Firm B's output is
sold to consumers for consumption, then Firm A;s output is known as an intermediate
good while Firm B's output is known as a final good. The calculation of GDP only
includes the value of Firm B's output and excludes Firm A's output to avoid double
counting.
For example, a car producer purchases the car parts and accessories from other producers
and its main role is to assemble all the parts and accessories to make it a complete car
before selling to its customers. If all the output produced by all firms are included in the
calculation of GDP, then the GDP will record the value of the completed car, the value of
the car battery, the car tyres and the car seats, among others. It will be counting the same
car twice and this is double-counting. To avoid double counting, only the final goods are
included in the calculation of GDP. Thus when the tyre manufacturers sell the 4 tyres to
the car producer, the tyres are intermediate goods, not final goods and the value will not
be included in GDP. Only the car producer's completed car is the final good and will be
included in the calculation of GDP.

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(c)

Produced in the country

The gross domestic product (GDP) measures the market values of all final goods and
services produced during a year by resources located in a country, regardless of who
owns those resources. The purpose of GDP is to keep track of the performance of an
economy and therefore it should only includes the value of output produced within the
geographical boundary of the economy. Hence the GDP of Singapore only includes the
goods and services produced within the geographical boundary of Singapore. It does not
matter whether the firms that produce these outputs are owned by Singapore or the
foreign countries.
In this context, the output produced by foreign factories located in Singapore is included
in Singapore GDP but the output own by Singapore located in a foreign country will not
be included in Singapore GDP. Good that are produced in Singapore but meant for
selling to foreigners, known as export, will be included in Singapore GDP. On the other
hand, goods that are available in Singapore but produced by other countries, known as
import, will not be included in Singapore GDP.
If we exclude the value of output produced by foreign firms located in Singapore and
include the value of output produced by Singapore firms located in foreign countries, the
value becomes Gross National Product (GNP).
(d)

Timeframe

GDP normally measures in the timeframe of one year and Singapore GDP for 2013
measures the value of final output produced in the beginning of 2013 until the end of
2013. If a product is produced in 2012, it should be reflected in the year 2012 GDP.
In this context GDP also ignores the value of second hand goods, such as resale
textbooks, resale houses and resale cars. The reason is that these goods were counted as
part of GDP in the year they were produced.
2.2

Calculation of Gross Domestic Product

The direct method of calculating GDP is to measure the market value of all final outputs
produced by the firms in the economy. The market value of final output is obtained by
multiplying the market price by the quantities of the output produced.
Assume that there are three firms produce three goods in an economy. Firm A produces
food, Firm B produces clothing and Firm C produces cars. The prices and quantities of
the three products in the year 2012 is reflected in Table 7.1

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Table 7.1: Calculation of GDP

Firm
A
B
C

Output
Food
Clothing
Computer

Price
$1
$2
$300

Quantity
1200
800
30

Total Value
$1200
$1600
$9000

Using the direct method, the GDP of the economy is $1200 + $1600 + $9000 = $11800.
2.3

Nominal GDP and Real GDP

Over the years, the price of goods and services will tend to increase. Thus when an
economy records a higher GDP value, it may be due to the economy produces more
output, the prices of the outputs increase or a combination of both. It is important to
distinguish between a higher GDP due to more output from a higher GDP due to higher
prices. This give rises to two different ways of calculating GDP: Nominal GDP and Real
GDP.
Nominal GDP is obtained by multiplying the current year output by the current year
price. For example, the year 2012 nominal GDP is obtained by multiplying 2012 prices
by 2012 quantities of all final output produced. The year 2013 nominal GDP is obtained
by multiplying 2013 prices with 2013 quantities of all final output produced.
If there is an increase in both the prices and/or the quantities of output over the years, the
nominal GDP will be higher but this higher value could be due to a higher prices, a
higher output quantity or both.
Real GDP is obtained by multiplying the current year output by the price of a
representative year, known as the base year. For example, if 2012 is the base year, then
the real GDP of 2013 is obtained by multiplying the 2012 prices by 2013 quantities of all
final output produced in 2013.
If there is an increase in real GDP, the economy must have produced more output since
the prices are kept constant at the base year. To measure economic growth over the
years, it is more meaningful to comparing real GDP instead of nominal GDP. This is
because real GDP reflects on real changes in production and eliminates changes due to
changes in the prices of output.
A numerical illustration of nominal GDP and real GDP is shown in Table 7.2. It involves
2 years of production, 2012 and 2013. Assume that 2012 is the base year.

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Table 7.2: Calculation of Nominal and Real GDP

2012
Firm
A
B
C

Output
Food
Clothing
Computer

Price
$1
$2
$300

2013
Quantity
1200
800
30

Price
$1.20
$2.20
$330

Quantity
1250
830
35

The nominal GDP for 2012 is ($1 x 1200) + ($2 x 800) + ($300 x 30) = $11800.
Since 2012 is the base year, the real GDP for 2012 is also $11800.
The nominal GDP for 2013 is ($1.20 x 1250) + ($2.20 x 830) + ($330 x 35) = $14876.
The real GDP for 2013 is ($1 x 1250) + ($2 x 830) + ($300 x 35) = $13410.
Note that the nominal GDP is higher than the real GDP since both prices and quantities
have increased over the period.
We are also interested in the growth rate of the economy. This is expressed as the
percentage change in the real GDP across the period.
Between 2012 and 2013, the nominal GDP growth rate is:
$14876-$11800 X 100% = 26.07%
$11800
The real GDP growth rate is:
$13410-$11800 X 100% = 13.64%
$11800
Note that with prices increase over the period, the real GDP growth rate will be lower
than the nominal GDP growth rate.

3.

Gross Domestic Product by Expenditure Method

In Section 2, we discussed the calculation of GDP by adding up the market value of final
output produced by the firms in the economy. Since the firm's output are purchased by
the consumers in the market, an equivalent way of measuring GDP is by calculating the
total spending on a countrys production. This is because total spending equals total
value of output in an economy. This is known as the expenditure method of calculating
GDP.

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The expenditure approach involves adding up the total spending, known as the aggregate
expenditure (AE) on all final goods and services produced during the year. The
aggregate expenditure is divided into four components : Consumption, investment,
government purchases and net exports.
(a)

Consumption

Consumption refers to the expenditure incurred by households to satisfy their needs. This
expenditure denoted by C and it consists of purchases of final goods and services by
households during the year.
The examples of consumption include household purchase of food, clothing, cars,
furniture, transportation, medical and education services. However, it does not inlude
purchase of houses.
(b)

Investment

Investment refers to the expenditure incurred in order to produce goods and services and
not for satisfaction of wants. It is denoted by I and there are three categories of
investment.
(i)
Physical capital investment: This refers to the expenditure incurred by firms to
produce goods and services. Examples include machinery purchased by firms, such as
computers and vehicles. It also includes the shops, offices, factories and buildings used
by the firm in its operation.
(ii)
Inventory investment: This refers to the stock of completed or semi-completed
goods which the firms stored in the warehouse instead of releasing them for sale in the
market. It is an investment as the firms may hold these stocks until a better time to
release them to the market to earn more profits. Inventories help the firms to deal with
unexpected change in the demand for their product so that the stocks can be released at a
good time and not for current consumption.
The firms will keep track of the value of their stocks at the warehouse at the end of the
year and compared this value to the beginning of the year. If there is a higher value of
stock over the period, inventory investment increases.
(iii) Residential investment: This refers to the purchase of newly constructed houses
by households. It is considered as an investment as house prices tend to increase over the
years unlike consumer goods which value tends to decrease over time. However, the
purchase of existing houses will not be included in the GDP. This is to avoid double
counting since every house can only be counted once in the GDP.
When calculating GDP using the expenditure method, the investment does not include
the purchases of existing financial assets, such as stocks and bonds. These represents a

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transfer of money from one party to another and there is no new goods or services being
produced in the period. These are financial investment which is meant for generating
returns for the investor and did not represent any production of goods and services in the
year as required in the GDP,
(c)

Government Spending

Besides households and firms, the government also incurs expenditures in order to
perform its function. This is denoted by G and Government purchases or government
spending, denote by G, includes spending by all levels of government for goods and
services.
Examples of government spending includes spending to provide national defence,
purchase weapons, build roads, parks, schools and hire workers to provide teaching
services in schools or medical services in government operated hospitals.
However, sometimes government gives money to the people without any condition. This
type is spending is called transfer payments. The examples include unemployment
benefits and other welfare benefits such as food or cash vouchers for the low income
people. These payments is a transfer of money from the government to the recipients.
Although it is a spending incurred by the government, it is not included in the calculation
of GDP since there is no corresponding goods and services being produced.
(4)

Net export

Net export, denoted by NX, is the value of a country exports (X) minus the value of its
imports (M).
When a country produces its products and sells to foreigners, the values of the output are
recorded in export and is included in the GDP. It is included because the production
occurs in the country. The fact that the goods or services are consumed by foreigners
does not matter as it is the location of the production that counts.
When a country purchases goods and services produced by foreign countries, the value of
these outputs will be recorded in the import. The import should be excluded from the
GDP since they are not produced within the country even though they are consumed by
the people in the country. Thus, part of the spending in the consumption, investment or
government spending could be on goods and services produced by foreign countries and
imported into the local country. They are collectively captured in the import component
to be excluded from the calculation of the GDP.
If the value of exports exceeds the value of the imports, net exports is positive. However,
if a country imports more than its exports, then the net export is negative.

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Thus C + I + G + X - M = C + I + G + NX = Aggregate expenditure = GDP

4.

GDP and Standard of Living

The main purpose of GDP is to measure the performance of the economy and compare
the performance of the economy over time. If we divide the real GDP of an economy by
its population, the value is called real GDP per capita and it is being used as an indicator
of the well being of the people in the country.
A country with a very high real GDP per capita in general implies that the people are
better off than the people in a country with a very low GDP per capita. However, there
are some limitations in using GDP to indicate the standard of living or the well being of
the people.
(a)

GDP ignores household production and underground economy

As mentioned in Section 2, GDP only records the value of output that transacts through
the market system. Thus the goods and services produced by family members of a
household will not be included in the GDP, eve though they tend to increase the welfare
of the household members. In a similar context, a country may have a very large
underground economy with productions not recorded in its GDP. This means the GDP
value may be low and the residents may actually have a large amount of output for
consumption. Hence the residents need not be worse off compared to that of another
country with higher GDP.
(b)

GDP ignores leisure

The well being of a person includes not just the amount of goods and services the person
can consume but also the amount of leisure that the person can enjoy. An economy that
requires its people to work for 12 hours per day will tend to have a higher GDP than
another economy that people only work for 8 hours per day. But it is difficult to
conclude that the latter will have a lower well being than the former based on GDP figure
alone since the latter will have more time for leisure activities.
(c)

GDP ignores impact on environment

A country can have a high GDP if it carries out large number of economic activities such
as building more houses, cultivate more land, extract more minerals from the earth and
create more offices and factories. However, it will tend to create pollution and damages
to the environment. The well being of the people includes a pleasant environment to live
with sufficient space and little pollution. Thus a high GDP may implies low well being if
it is associated with polluted environment.

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(d)

GDP ignores distribution of income

GDP records the total value of output of an economy but did not consider the distribution
of output in the economy. The term GDP per capita simply divide the GDP by the
population and assume everyone gets an equal share of the output. In reality, the
distribution of income can be very unequal such that majority of the output are distributed
to a small minority in the economy, leaving the majority in poverty situation. In this
case, a high GDP need not implies a high welfare for the people in the economy in
general.

5.

Business Cycle

Over a sufficiently long period of time, the GDP of an economy tend to increase over the
years. This is mainly due to improvement in technology that results in more output being
produced. It can also be attributed to an improvement in the qualities of resources, such
as education that increase the productivity of the workers. It may also be due to more
resources in the country, such as an increase in the population growth rate or the
development of vacant land in the economy.
Although the long term trend of the GDP is increasing, the actual GDP tend to fluctuate
in a cyclical manner. This is known as the business cycles. There are times where the
actual GDP is higher and times it is lower than the long term trend and the frequent rises
and falls of the GDP forms the business cycle. A typical business cycle is shown in
Figure 7.1.
Figure 7.1: Business Cycle
GDP
C
Trend line
A
Business cycle
D
B

Time

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5.1

Analysis of Business Cycle

In Figure 7.1, the upward sloping straight line shows the long term trend of the GDP of
the economy,
There are several cycles in Figure 7.1 For each cycle, we define the following terms:
(a)

Peak

This refers to the highest point of a cycle. In Figure 7.1, point A and point C are peaks.
(b)

Trough

This refers to the highest point of a cycle. In Figure 7.1, point B and point D are peaks.
(c)

Expansion

The period between the trough and the subsequent peak is an expansion. In Figure 7.1,
the duration from point B to point C is an expansion.
(d)

Recession

The period between the peak and next the trough is a recession. In Figure 7.1, the
duration from point A to point B, and from point C to point D are recessions.
Technically, a recession is a milder contraction where the total output decline for 2
quarters or 6 months.
A depression is a prolonged recession, usually accompany with a sharp reduction in the
nations total output with high unemployment.
A recession begins after the previous expansion has reached its peak and continues until
the economy reaches a trough.

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Discussion Questions

Question 1
If prices become higher over the year and the economy produces the same products over
the year, then for the current year,
(a)
(b)
(c)
(d)

the nominal real GDP will be higher than the real GDP
the nominal real GDP will be the same as the real GDP
the nominal real GDP will be lower than the real GDP
there will be recession in the economy

Question 2
Which of the following transaction is classified under consumption in GDP
(a) A company buy a computer
(b) A Tourist buy a shirt
(c) A hawker buy fish and vegetables to prepare food for its customers
(d) A person watch a movie in a theatre
Question 3
Which of the following statement regarding GDP is correct?
(a) GDP includes all output produced in an economy
(b) Nominal GDP is always larger than real GDP
(c) real GDP is always larger than nominal GDP
(d) If real GDP increases, the country must have produce more output

Question 4
Which of the following will not cause a recession?
(a) A war involving foreign countries
(b) A general strike in the economy
(c) An unsuccessful government policy
(d) A stock and property market boom

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Question 5
Which of the following statement regarding business cycle is false?
(a) From a peak to a trough is a recession
(b) From a trough to a peak is an expansion
(c) Business cycle consists of upswing and downswing
(d) We can predict the upswing and downswing of business cycle accurately.
Question 6
Classify the following expenditures according to C, I, G, X or M
(a)
Tourists buy goods in Singapore
(b)
Government hire teachers to teach in primary school
(c)
Patients seek medical treatment in a local clinic
(d)
Firms store goods in warehouses
Question 7
Refer to the table below which shows three products, bread, shirt and books which are
produced by the firms in an economy over 2012 and 2013. The base year is 2012.
2012
Output
Bread
Shirt
Books

Price
$0.50
$4
$20

2013
Quantity
80
50
120

Price
$0.60
$4.80
$23

Quantity
90
60
122

(a)
Compute the nominal GDP of the economy in 2012 and 2013 and calculate the
GDP growth rate based on the nominal GDP.
(b)
Computer the real GDP of the economy in 2012 and 2013 and calculate the real
GDP growth rate based on the real GDP.
(c)

What is the difference between nominal GDP and real GDP?

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ELEMENTS OF ECONOMICS
SESSION 8
INFLATION
At the end of the session, students should be able to:
1.
2.
3.

4.
5.
6.

Define inflation.
Discuss the types of inflation.
Apply consumer price index to measure inflation.
Explain the limitation of consumer price index in measuring cost of living
Apply GDP deflator to measure inflation
Discuss the costs of inflation

________________________________________________________________________

1.

Introduction

In this session, we begin with a definition of inflation and discuss the types of inflation.
Next we go through the creation of consumer price index and discuss its uses and
limitations in measuring the cost of living. Then we discuss the uses of GDP deflator in
measuring cost of living and finally we analyse the cost of inflation..
2

Inflation

Inflation is a sustained increase in the average level of prices. Since there are many
goods and services in the economy, we consider the average of all these prices, known as
price level, when analyzing inflation. When price level increases, inflation occurs and
the inflation rate is measured by the percentage change in the price level.
A very high inflation is called hyperinflation, which is defined as price on the average
increases by about 50% or more per month. A sustained decrease in the average level of
prices is called deflation.
Inflation is measured on an annual basis. The annual inflation rate equals the percentage
increase in the average prices of goods and services, known as the price level over the
period of one year.
2.1

Types of Inflation

Inflation can be depicted as a continuing increase in the economys price level resulting
from an increase in the total demand for output or a decrease in the total supply of output.
Thus there are two types of inflation: demand pull inflation and cost push inflation.

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(a)

Demand-pull inflation

Demand pull inflation refers to inflation due to higher demand for output. When the
households, the firms, the government and the foreigners want to demand for more goods
and services, they will tend to bid up the price of goods and services, hence inflation
occurs.
Recall in Session 7 that the total spending in an economy can be divided into
consumption, investment, government spending and net exports, we can also analyze the
demand for output in these four categories that may create demand pull inflation.
For example, when consumer income increases or when consumers are more optimistic
about the future, then there will be a higher level of consumption and hence higher
demand for output. This will result in demand pull inflation.
When interest rate decreases or when firms become more optimistic, the firms will carry
out more investment and there will be greater demand for output. This will create
demand pull inflation.
When the government implement policies to increase spending in the countries or reduce
taxes in the country, the action may also result in demand pull inflation. Increase in
government spending add on to output demanded in the country, while a tax cut increases
the take home income of the people which increases their ability to demand for more
output. One more method is for the government to make interest rate lower so that
people will borrow more to consume more and firms will borrow ore to investment more.
All these actions may trigger demand pull inflation.
Demand pull inflation may also occur due to higher net export. If the foreign countries
encounter an expansion, the foreigners will have higher income and will buy more
products from the local economy. Thus the local economy encounters a higher demand
for its product and the demand pull inflation may occur.
(b)

Cost-push inflation

Cost push inflation arises firms cut down production, resulting in shortage of output in
the economy and thereby drive up the prices of goods and services in general. This
occurs when resources become more expensive which increases the production costs.
When it is more expensive to acquire resources, firms will hire less resources and
produce less output. This will create a shortage of output at existing price level, price
level will increase and inflation occurs.
When cost push inflation occurs, it means not only prices are higher but the economy also
produces less output. Thus there is a combination of inflation and recession in the
country and this phenomenon is known as stagflation stagflation.

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Cost push inflation occurs whenever there is a higher resource price. Thus when price of
oil or other important raw materials increase, cost push inflation occurs. It may also
occur when workers demand for higher wages through the labour union demand, when
landlord charges a higher rental or when capital goods producers increase their prices
Note that demand pull inflation results in a higher price level and real GDP. Thus the
higher real GDP partly offset the negative effect of higher price level. In this sense a
demand pull inflation is better than a cost push inflation. A cost push inflation results in
a higher price level and a lower real GDP which means the people in the country are
poorer and goods and services are also becoming more expensive and people are affected
negatively in both situations.
3

Consumer Price Index

Inflation is measured by the percentage of change in the price index over the period of
one year. The most common type of price index used to measure inflation is the
consumer price index (CPI). This is a price index that keep tracks of a basket of goods
and services purchased by a typical household for consumption.
3.1

Computation of CPI

The definition of CPI is as follows:

CPI = Cost of a typical basket at current year
Cost of same basket at base year

X 100

To calculate GDP deflator, we will need information on the price and quantities of the
products included in a typical basket of consumer goods and services in the time periods
and also which period is the base period.
For example, Table 8.1 shows the price and quantities of three consumer items, food,
clothing and transportation in 2011, 2012 and 2013 which a typical household will
purchase.
Table 8.1: Calculation of CPI
Item
Food
Clothing
Transportation

Quantity
100
20
50

Price in 2011
$1
$2
$3

Price in 2012
$1.20
$2.50
$3.30

Price in 2013
$1.30
$2.80
$4

The basket will consists of 100 units of food, 20 units of clothing and 50 units of
transportation. The quantity will not change when computing the CPI.

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In 2011, the cost of this basket is ($1 X 100) + ($2 X 20) + ($3 X 50) = $290
In 2012, the cost of this basket is ($1.20 X 100) + ($2.50 X 20) + ($3.30 X 50) = $335
In 2013, the cost of this basket is ($1.30 X 100) + ($2.80 X 20) + ($4 X 50) = $386
Select 2011 as the base year. The base year CPI is always 100.
In 2012, the CPI is ($335/$290) X 100 = 115.52
In 2013, the CPI is ($386/$290) X 100 = 133.1
3.2

From CPI to Inflation Rate

Once the CPI are computed, we can determine the inflation rate between the two periods
by the percentage change in the CPI. An example is shown in Table 8.2.
Table 8.2: CPI and Inflation Rate
Year
2009 (Base Year)
2010
2011
2012
2013

GDP Deflator
100
103
108
112
110

From Table 8.2, we can compute that the inflation rate by computing the percentage
change of two successive CPI.
Between 2011 and 2012, the inflation rate is (112-108)/108 X 100% = 3.7%.
The inflation rate between 2012 and 2013 is (110 - 112)/112 X 100% = -1.79%
A positive inflation means prices have in general increase over the period. A negative
inflation, known as deflation, means prices have actually decrease over the period. It is
more common for an economy to encounter inflation rather than deflation.
3.3

Uses of CPI

CPI is mainly used to measure the inflation rate of an economy. For two successive CPI
the percentage change in the CPI is the inflation rate over the period. It is used as an
indicator of the cost of living changes during the period.

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With this indicator of cost of living, workers can used it as a basis to request for higher
nominal wages to compensate for the higher cost of living, so that their standard of living
will not be eroded due to inflation. The government can also use it to adjust the nominal
amount of welfare benefits to give to the recipients so that their welfare is not affected by
inflation.
The CPI can also be used to adjust the nominal value into the real value. For example,
real wage = nominal wage divided by CPI X 100. Similarly real interest rate = nominal
interest rate less inflation rate which is obtained from changes in the CPI.
3.4

Limitation of CPI

Although CPI is widely used in measuring the inflation rate in an economy, it has some
limitations in indicating the cost of living for households and it tends to overestimate the
actual cost of living. This is due to several bias embedded in the computation of CPI, the
substitution bias, the location bias and the quality adjustment bias.
(a)

The Substitution Bias

CPI assumes that households continue to buy the same product when the price has
increased over time. However, this is not the case in practice as households constantly
substituting the expensive product with the cheaper product to stretch their income.
Hence when a product becomes more expensive, households will replace it by a cheaper
substitutes, such as changing from a premium brand product to a more common brand
product that is cheaper. In this case the actual cost of living incurred by the households
will be lower than the magnitude reflected by the changes in the CPI.
(b)

The Location Bias

The location bias occurs when consumers change the location of their purchase when the
price of the product increases. For example, consumers may purchase a product online
instead of buying from a shop, a change to purchase from a outlet located at the suburban
area instead of at the more expensive urban area. Thus the actual cost of living for the
households will be lower than the amount reflected in the CPI.
(c)

The Quality Adjustment Bias

Over the years, a product tends to have improvement in the quality and part of the
increase in the price actually reflects an improvement in the quality. For example, the
bus fare is now higher than before because the bus are air-conditioned and install more
comfortable seats. Hence when the consumers purchase the current product with better
quality, the higher price paid by the consumers cannot be solely attributed to inflation.

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When these biases occur, the CPI tend to overestimate the actual cost of living
encountered by households in the economy. This means if the CPI shows a 3% increase
over the period, the actual cost of living increase may only be about 2%.
In addition, there is also the possibility of new product bias but the effect on CPI is that it
may underestimate the actual cost of living by households, unlike the other three biases.
(d)

New Product Bias

New product bias occurs when a new product is being introduced to the market which
households purchase and it is not included in the CPI. New products tend to be better
than existing product and are likely to be more expensive than the existing product.
Hence when consumers purchase the new products, their actual cost of living will be
higher than the amount reflected in the CPI. But in the event that the new products are
cheaper than the existing product due to technological breakthrough and large scale
production, then CPI will again be overestimating the actual cost of living.

4.

GDP Deflator

Another price index that can be used to measure inflation rate in an economy is the GDP
deflator. Unlike CPI which is based on a basket of goods and services, the GDP deflator
keep track of the prices of goods and services included in the computation of the GDP of
the economy.
4.1

Computation of GDP Deflator

The definition of GDP deflator is as follows:

GDP deflator = Nominal GDP
Real GDP

X 100

To calculate GDP deflator, we will need information on the price and quantities of the
output included in the GDP over the time periods and also which period is the base
period.
For example, if the nominal GDP in 2013 is $128,000 while the real GDP in 2013 is
$115,800, then the GDP deflator is ($128,000/ $115,800) X 100 = 110.54.
Once the GDP deflator are computed, we can determine the inflation rate between the
two periods by the percentage change in the GDP deflator. An example is shown in
Table 8.3.

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Table 8.3: GDP Deflator and Inflation Rate

Year
2009 (Base Year)
2010
2011
2012
2013

GDP Deflator
100
115
123
128
131

From Table 8.3, we can compute that the inflation rate by computing the percentage
change of two successive GDP deflator.
Between 2011 and 2012, the inflation rate is (128-123)/123 X 100% = 4.07%.
The inflation rate between 2012 and 2013 is (131 - 128)/128 X 100% = 2.34%
4.2

Comparison Between CPI and GDP Deflator

CPI and GDP deflator are both price indexes to measure the change in prices of goods
and services over time. They tend to move in the same direction but may not move by
the same magnitude. Thus they may give different inflation rate for the same period and
we need to exercise our judgement on which inflation rate to use in decision making.
The reason why CPI and GDP deflator may give different inflation rate is that they keep
track of different goods and services in their own index. For CPI, the interest is to
measure household's cost of living and hence the items are consumer items, which could
be locally produced or imported. On the other hand, GDP deflator keeps track of the
prices of goods and services included in the GDP, which by definition will only include
those output produced within the country and exclude imported items. It is more useful
to measure the competitiveness of a country using GDP deflator instead of CPI.
5

Costs of Inflation

If inflation rate is low and stable, then the cost to the economy is very low, mainly in the
form of menu cost and the shoe leather cost.
(a)

Menu cost

Menu cost refers to the cost incurred by the sellers who have to change their price list due
to inflation. Time and effort are needed to remove the old price list and replace it by the
new price list and this is a cost to the producers.

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(b)

Shoe leather cost

Shoe leather cost refers to the time and effort needed by the consumers who need to
constantly replace their money which run out faster during inflation. The time needed
and the inconvenience incurred when consumers need to go to the banks or ATM
machines frequently is a cost created by inflation.
However, in the event that the inflation rate is high and unstable, then it can be very
disrupting to the operations of the economy and the cost can be very severe. Inflation
distorts the signal send out by price as a resource allocator and hence results in inefficient
allocation of resources in the market system. It favours borrowers and penalize lenders,
and it favours variable income earners and penalize fixed income earners. It makes
planning for retirement difficult and discourages consumption. It makes planning for
investment difficult and discourages investment.

6.

Discussion Questions

Question 1
Which of the following will not cause a demand pull inflation?
(a)
(b)
(c)
(d)

Government increases transfer payment to the people

Banks reduces their interest rates
Workers demand for higher wages
Consumers are more confident about the future

Question 2
Which of the following will not cause a cost push inflation?
(a)
(b)
(c)
(d)

Foreigners buy more product from an economy

Workers demand for higher wages
Oil price increases
Land price becomes higher due to shortage of usable land

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Question 3
If in the year 2012 the price of a basket of goods and service is $1500 and in the year
2013, the price of the same basket becomes $1565, what is the CPI in 2013 if 2012 is the
base year?
(a)
(b)
(c)
(d)

101.16
102.24
103.18
104.33

Question 4
If the CPI for 2012 is 118 and the CPI for 2013 is 119.2, the inflation rate between 2012
and 2013 is
(a)
(b)
(c)
(d)

0.88%
1.02%
1.65%
2.18%

Question 5
In the presence of substitution bias and quality adjustment bias, which of the following
statements regarding CPI is correct?
(a)
(b)
(c)
(d)

CPI underestimates the actual cost of living in the economy.

CPI overestimates the actual cost of living in the economy.
CPI accurately estimates the actual cost of living in the economy.
CPI will give the same estimates of cost of living as GDP deflator in the
economy.

Question 6
(a)

Explain why inflation is a cost to an economy.

(b)
Other things equal, a demand pull inflation is better than a cost push inflation. Do
you agree? Explain.

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Question 7
Refer to the table below and compute the CPI for 2012 and 2013, using 2012 as the base
year.
Item
Bread
Fish
Vegetable
(a)

Quantity
10
25
40

Price in 2012
$3
$5
$2

Price in 2013
$3.50
$4.50
$2.80

What is the inflation rate between 2012 and 2013?

(b)
Do you expect this rate to accurately reflect changes in the cost of living of
households from 2012 to 2013? Explain.

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ELEMENTS OF ECONOMICS
SESSION 9
UNEMPLOYMENT
At the end of the session, students should be able to:
1.
Define unemployment
2.
Calculate labour force statistics.
3.
Describe the types of unemployment.
4.
Discuss the costs of unemployment
5.
Explain the methods to reduce unemployment
________________________________________________________________________
1.

Introduction

In this session, we begin with a definition of unemployment. Next we introduce various

labour force statistics and explain the method to calculate these statistics. Then we
discuss the different types of unemployment. Finally, we analyze the costs of
unemployment and discuss the methods to reduce unemployment.
2.

Definition of Unemployment

Just because a person is not working does not mean that the person is unemployed. This
is because a person may choose not to work if he or she has the means of living without
working. To be considered as unemployed, there are three conditions to satisfy.
A person is considered as unemployed if:
(i)

The person is willing to work

(ii)

The person is able to work

(iii)

The person had spent some time searching for a job but is still unable to find one.

A long stretch of unemployment can have a profound effect on an individual and the
society. It is generally true that if a person remains unemployed for a longer period of
time, it will become more and more difficult for the person to gain employment and
eventually the person may be permanently unemployed. There will be very high cost
incurred by the individuals and the society if a person is unemployed for a long period of
time. Thus one of the major tasks of government is to reduce unemployment in a
economy.

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Labour Force Statistics

When studying unemployment, it is important to know how to measure some labour force
statistics. These labour force statistics include labour force, labour force participation
rate and unemployment rate.
In an economy, everyone is part of the population but not all of them are eligible to enter
the labour force to seek employment. Depending on the age determined by the
government, a person can only seek employment legally if he or she has reached the
particular age. In Singapore, the legal age to enter the labour force is 15 years old while
in US it is 16 years old. Thus we can broadly divide the population of a country into
working age population and underage population. We are interested in only analyzing
the working age population.
3.1

The Labour Force

Among the working age population, not all wish to seek employment. For example, there
will be full time housewives who prefer home making instead of working. There will be
full time students who prefer study instead of working. There will be retirees who had
retired from their work and prefer not to work anymore. There will be people who have
other means of living and choose not to work. There will also sick or handicapped
people are are not able to work. These are people excluded from the labour force.
The labour force comprises all those people holding a job or registered as being willing
and available for work and had spent some time searching for a job. Thus labour force is
the sum of the employed and unemployed.
Labour Force = Employed + Unemployed.
The employed consist of the full time workers as well as part time workers. If a person
wishes to work full time but is able to find a part time job, the person is considered as
under-employed and is still counted as employed in the labour force statistics.
3.2

Labour Force Participation Rate

The number of people in the labour force represents the potential labour resource that can
contribute to the production of goods and services in an economy. We are interested to
find out what is the percentage of the labour force out of the entire working age
population. This is the labour force participation rate.
Labour Force Participation Rate =

Labour Force
Working Age Population

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X 100%

3.3

Unemployment rate

The unemployment rate is the percentage of the labour force without a job but registered
as being willing and available for work and had spent some time searching for a job yet is
still unable to find one.
Unemployment rate =

Unemployed
Labour force

X 100%

The unemployment rate of an economy is affected by many factors. Among them, the
health of an economy is an important factor.
During expansion period, the
unemployment tends to be lower while during recession period the unemployment rate
tends to be higher.
3.4

Numerical Illustration

Consider an economy consists of 100 persons. There are 10 persons below the age of 15
which is the legal working age of the population. Among those who are 15 years and
above, there are 50 full time workers, 10 part time workers, 5 retirees, 5 housewives and
8 full time students. Out of the remaining 12 persons, only 6 are actively searching for
job.
The working age population is 90.
The employed = 50 + 10 = 60.
The unemployed = 6.
Labour Force = 60 + 6 = 66
Labour Force Participation Rate = (66/90) X 100% = 73.33%
Unemployment rate = (6/66) X 100% = 9.09%.
3.5

Discouraged Worker

When a person is actively searching for a job, the person is considered as an unemployed
and is counted as part of the labour force. However, if after a long period of job search a
person is still unable to find a job, then it is likely that the person may believe that it is
impossible to find a job and may stop the job searching. The person then becomes a
discouraged worker.

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A discouraged worker is one who stopped all the job searching efforts after a long period
of job hunt. The person become some discouraged that he simply give up and may prefer
not to work at all.
When a person becomes a discouraged worker, he is no longer considered as an
unemployed since by definition an unemployed person has to be actively involved in job
search. The person is considered as voluntarily not willing to work and will not longer be
included in the labour force.
The issue with discouraged worker is that it may mask the extent of unemployment in an
economy. Since discouraged workers are no longer considered as unemployed and are
taken out of the labour force, when there are more discouraged workers in the economy,
the unemployment rate may actually decrease.
4

Types of unemployment

There are many reasons why unemployment occurs. We divide the unemployment into
five main types.
(a)

Frictional unemployment

Frictional unemployment refers to unemployment due to friction in the economy and this
friction is caused by imperfect information. The workers may have the skill demanded
but they do not know which company offers the best prospects for their skills. Thus they
need time to search for the best company and they are unemployed before they accept an
offer. Likewise companies may need certain type of workers with certain skills but are
not sure who will be the best fit to the jobs. It is through time that the firms encountered
sufficient workers then it can select the best fit to the job requirements.
Both firms and potential workers need time to explore the job market. Employers need
time to find out about the talent available, and potential workers need time to find out
about opportunities and prospects from different companies. The time required to bring
together workers and firms result in frictional unemployment.
Frictional unemployment occurs because of imperfect information, thus creating friction
in the economy. If information flow is perfect, then workers immediately know which
company offers the best return for their skills. They would have approach that specific
company immediately without having to be unemployed for a period of time. This also
applies to people who hopped among jobs in the economy.
Frictional unemployment tends to be less serious as it is temporary in nature. Given
enough time workers will eventually refer the information and be employed. In fact, it
may be beneficial to have a small amount of frictional unemployment. If every job
seekers simply take up the first job offered to them, frictional unemployment may be
lower but the first job offered may not be a best job that allows the job seekers to fully

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utilize his talent and ability. A small amount of frictional unemployment in the4 sense
that job seekers wait for better job opportunities may result in a better match-up between
workers and jobs, so the economy becomes more efficient.
(b)

Structural unemployment

Structural unemployment refers to unemployment arising because of changes in the

economy. Changes may occur in demand or production which create mismatch of skills
and job opportunities. Thus in the economy, on one hand, there are newly created
companies which need to employ many workers with relevant skills. On the other hand
there are workers who are laid off because of demand pattern and production changes and
anxiously searching for jobs. But the two simply could not match.
Since economy is dynamic, at any time there may be technology break through which
improve product6ion process. This will lead to certain jobs to be replaced by machines
and result in unemployment. An example is the invention of ATM in the banking
industry replaces the needs of bank tellers in the banks. Another example is the
possibility of online purchases that require the needs to employ sales person.
Another cause of structural unemployment is when there is a change in consumer taste.
If consumers have weaker preference for a product, the demand for the product will
decrease and firms will cut down production of the product, thus creating unemployment.
An example is the invention of computers as word processors which replace the
typewriters and thus typewriter firms become obsolete.
A third possibility is due to changes in operational cost which companies decide to
relocate elsewhere and retrench their workers in the local environment. An example will
be the manufacturing of low end products that relocated from high cost Singapore to
lower cost neighbouring and regional countries such as China, Malaysia and Indonesia..
Structural unemployment tends to be more long lasting compared to frictional
unemployment. When there is a change in technology, consumer taste or production
structure resulting in the loss of jobs, the jobs are unlikely to return to the economy and
this type of unemployment will not be reduced through time.
(c)

Cyclical unemployment

Cyclical unemployment refers to unemployment due to fluctuation of business cycle.

When there is a down-turn in the business cycle, the possibility of a recession will make
people more careful with their money. Everyone will try to save more and spend less,
resulting in lesser demand for all outputs. The reduction in total demand for goods and
services means firms need not produce as much output as before. Firms will reduce
production, require lesser workers and hence certain workers are retrenched.

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As production declines during recessions, many firms reduce their demand for inputs,
including labour. Cyclical unemployment is the increase in unemployment that occurs
during recession.
(d)

Classical unemployment

Classical unemployment refers to unemployment created when the wage is deliberately

maintained above the equilibrium level. The equilibrium level is determined by the point
at which the labour supply and labour demand schedule intersects.
Classical unemployment may be caused by the exercise of union labour power or by
minimum wage law. A strong labour union may demand for a high wage by threatening
to withhold supply of labour at any wage below. Or the government may enact a
minimum wage above the equilibrium level with intention to assist workers.
The effect of classical unemployment is is shown in Figure 9.1. The higher wage W1 will
make working attractive and hence more workers are willing to work. Thus the quantity
of labour supplied is at Q1. But at the high wage, firms will perceive workers to be
expensive and will demand for lesser workers and the quantity of labour demanded is Q2.
The result is that at the given wage, the quantity of workers supplied exceeds the quantity
of workers demanded by firms, hence classical unemployment occurs.
Figure 9.1: Classical Unemployment
Wage
Labour Supply curve
Surplus

W1

E
WE
Labour Demand curve
Q1
(e)

Q2

Quantity of labour

Seasonal Unemployment

Seasonal unemployment refers to unemployment due to changes in season. For example,

during monsoon season, it may not be safe for fishermen to catch fish from the sea and
thence they become unemployed. During the summer season the ski resorts will close
and the workers become unemployed until the winter season arrives.

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Thus seasonal unemployment is temporary in nature but will be occurring in a regular

basis over the years.
5.

Costs of Unemployment

The cost of unemployment is directly related to the duration of unemployment. If the

unemployment is a short duration, the skills of the workers remain relevant and still in
demand, the unemployed can rely on savings or unemployment benefits to finance the
basic needs. In this case, the cost will be low.
In the event of long term unemployment, the costs can be very high. We can broadly
divide the costs into economic costs and social costs.
5.1

Economic Costs

A worker is a labour resource which can contributes to the GDP of an economy. If a

person is unemployed, the person cannot contribute to the production of output in the
economy and hence the GDP will decrease.
In addition, if a person remains unemployed for a long period of time, his productivity
will tend to reduce due to lack of on-the-job practice. The skills may become irrelevant
and the knowledge may become obsolete, making itmore difficult for the person to find a
job.
For countries that provide generous welfare benefits, such as unemployment benefits,
unemployment will be a drain on the government resources. Instead of allocating the
resources for productive use such as infrastructure development, the resources are being
allocated to finance the cost of living of the people and this will affect the long term
growth rate of the country.
5.2

Social Cost

Unemployment can also impose a high cost to the society. Statistically, it is discovered
that when unemployment rate increases, crime rate also increases. There are also more
cases of family broken down, divorce rate and juvenile delinquency during periods of
high unemployment. Child abuse cases are also more common during periods of
widespread unemployment and people may lost their self esteem and self confidence if
they remain unemployed for a long period of time.

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6.

Reducing Unemployment and Full Employment

As the cost of unemployment could be very severe, it is important for the government to
implement means and ways to reduce the unemployment in the economy.
6.1

Methods to Reduce Unemployment

The methods to reduce unemployment depend on the types of unemployment and require
effort from the individuals, the firms and the government.
(a)

Frictional Unemployment

Frictional unemployment occurs due to imperfect information in the economy. The skills
of the workers are relevant and there are firms which require such skills but the two
parties did not know each other until information becomes available through time. To
reduce frictional unemployment, firms and potential workers can participate actively in
career exhibitions; engage the services of job agency, making use of better
communications channels such as internet and mobile devices to facilitate the flow of
information.
(b)

Structural Unemployment

Structural unemployment arises out of a mismatch in skills and job vacancies. To reduce
structural unemployment, the people will need to acquire the relevant skills to meet the
job needs. Thus the workers will have to undergo training and re-training. Workers need
to be receptive to training and willing to undergo training and education. Firms and the
government can help to reduce structural unemployment by providing financial and other
incentives to workers to receive training.
(c)

Cyclical Unemployment

Cyclical unemployment arises out of people buying lesser output during recession. This
is a problem concerning the whole economy and there is nothing much an individual or a
firm can do to solve the problem. Only government can gather enough resources to pull
the economy out of recession. To reduce cyclical unemployment, government can
implement expansionary policies, such as fiscal or monetary policy to increase the total
demand for output in an economy. Government can increase spending, reduce taxes,
increase transfer payments or increase money supply to increase total demand for output.
When the total demand for goods and services increases in the economy, firms will need
to produce more output and there will be greater demand for workers in the country.

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(d)

Classical Unemployment

Classical unemployment is due to higher than the market equilibrium wage rate, mainly
due to excessive demand by labour union or the minimum wage law. To reduce classical
unemployment, it is important for the wage rate to follow the market equilibrium level.
This requires the government to abolish the minimum wage law and impose curbs the
power of labour union to make wage rate more responsive to market forces.
(e)

Seasonal Unemployment

Seasonal unemployment is similar to structural unemployment in that the skills and

knowledge of the workers become irrelevant when there is a change of seasons. The only
way to reduce seasonal unemployment is to learn different skills relevant to different
seasons.
6.2

Full Employment

No matter how many policies implemented by the government, it is not possible for an
economy to achieve zero unemployment. Even the economy is growing very rapidly, at
any time there will be people who are not satisfied with their current job and prefer to
quit the job to search for another one. Thus there will be frictional unemployment.
Likewise at any time, changes will occur in an economy and these will bound to make
some people unemployed because their jobs can be replaced by machines due to
improvement in technology, or their products are being replaced by new and better
products and hence their skills become obsolete, Thus there will be structural
unemployment occurs. Only cyclical unemployment can be completely eliminated
during an expansion period. Hence it is very natural for an economy to have a low but
positive unemployment rate. This unemployment rate is known as the natural rate of
unemployment.
Thus the term full employment does not refer to zero unemployment. Rather it refers to
the economy is having the natural rate of unemployment. For s small economy like
Singapore, the natural rate of unemployment is about 2%. For a large economy like the
US, the natural rate of unemployment is about 5%.
When an economy has fully utilized all its resources in a sustainable way, the output it
produces is known as the potential output, and the unemployment rate that accompanies
he potential output is the natural rate of unemployment. It consists of mainly frictional
unemployment and structural unemployment but no cyclical unemployment.

118

7.

Discussion Questions

Question 1
Which of the following regarding unemployment is correct?
(a)
(b)
(c)
(d)

Full time students are part of the labour force

With more discouraged workers, unemployment may actually decrease
If there are more graduates enter the job market, clasical unemployment occurs
An unemployed person is not part of the labour force

Question 2
Given that there are 75 employed person, 25 unemployed person and 150 persons of
working age in a city, the labour force participation rate for the city is
(a)
(b)
(c)
(d)

55.8%
62.4%
66.7%
72,4%

Question 3
When two companies merge and some workers are retrenched, what type of
unemployment is this?
(a) Structural unemployment
(b) Frictional unemployment
(c) Cyclical unemployment
(d) Classical unemployment

Question 4
When the government implements a minimum wage law, which type of unemployment
will be created?
(a) Structural unemployment
(b) Frictional unemployment
(c) Cyclical unemployment
(d) Classical unemployment

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Question 5
Which of the following unemployment could be beneficial to an economy?
(a) Structural unemployment
(b) Frictional unemployment
(c) Cyclical unemployment
(d) Classical unemployment
Question 6
Refer to the situations below and explain what type of unemployment has occurred for
each of the situations:
(a)
(b)
(c)
(d)

John was retrenched as the toy factory that he works is unable to compete with
cheaper import.
Mary has just completed her diploma study and is waiting for a job interview.
Peter was retrenched as the company he works at decide to employ lesser workers
after an increase in the minimum wage
Susan losses her sales assistant jobs due to poor business in the shop during
recession

Question 7
An economy has 1000 persons where 200 are below the working age of 15 years.
Among those whose are 15 or more, there are 450 full time workers, 100 part time
workers, 50 full time students, 30 housewives and 20 retirees. 50 of the remaining
becomes discouraged workers and the rest are are actively searching for a job,
Based on the information given, compute the following labour statistics:
(a)

The labour force

(b)

The labour force participation rate

(c)

The unemployment rate.

120

ELEMENTS OF ECONOMICS
SESSION 10
AGGREGATE EXPENDITURE AND FISCAL POLICY
At the end of the session, students should be able to:
1.
Derive the aggregate expenditure function.
2.
Explain the components of aggregate expenditure.
3.
Explain the relationship between aggregate expenditure and real GDP
4.
Analyze the equilibrium of the economy using Keynesian Cross Model.
5.
Define fiscal policy
6.
Analyze the effects of fiscal policy on an economy.
________________________________________________________________________
1.

Introduction

In this session, we begin with a discussion of aggregate expenditure function and its
components. Next, we determine the equilibrium output level from the aggregate
expenditure function using Keynesian Cross Model. Then we introduce the concept of
fiscal policy and finally we analyze the effects of fiscal policy on an economy.
2

Aggregate expenditure function

The aggregate expenditure (AE) function shows the total expenditure in an economy,
assuming that price level is fixed.
Recall that in Session 7, we use the expenditure method to calculate the GDP of an
economy. There are four components of expenditures in the economy, namely
households expenditures in the form of consumption (C), firms expenditures in the form
of investment (I), spending incurred by the government which is the government
expenditure (G) and the expenditures of foreigners in the form of net exports (NX) which
is export (X) less import (M). We will use these four components to form the aggregate
expenditure of an economy. Thus AE = C + I + G + NX or AE = C + I + G + X - M. We
will analyze each of these components and the factors that affect these components.
2.1

The Consumption Function

The consumption function shows the relationship between consumption and disposable
income. Disposable income is the income earned by households minus taxes. Other
things constant, the relationship between consumption and disposable income is positive,

121

indicating the higher the disposable income level, the higher is the consumption level. A
typical consumption function is reflected in Figure 10.1
Figure 10.1: Consumption Function
Consumption
Consumption Function

C
YD
C0
Disposable Income
In Figure 10.1, the consumption function has a Y-intercept of C0 and a slope of C/ YD,
where C is the consumption and YD the disposable income. Even when disposable
income equals 0, people still need to have some positive consumption in order to satisfy
their basic needs. It is assumed that people will withdraw their savings to finance their
consumptions in the event of low or zero disposable income. Thus C0 is the consumption
level when the disposable income equals 0.
The higher the disposable income, the higher is the consumption level. Thus the
consumption function is upward sloping. In other words, the consumption function is an
induced function of Real GDP or income. It is an induced function because a higher
income induces consumption to consume more.
The slope of the consumption function is called the marginal propensity to consume
(MPC), as defined by the famous economist Keynes. It is defined as the change in
consumption divided by the change in disposable income. Keynes believed that when an
individuals income increases, he will only spend a portion of the increased income and
he will save the remainder. Thus we have 0 < MPC < 1.
MPC

Change in consumption
Change in disposable income

In a similar context, the marginal propensity to save (MPS) is defined as the change in
saving divided by the change in disposable income

122

MPS =

Change in saving
Change in disposable income

Assume that all the disposable income is either spent or saved, we have the equation
MPC + MPS = 1
The mathematical expression of the consumption function is C = C0 + C1YD or
alternatively, C = C0 + C1(Y T). C0 is the autonomous consumption which is the Yintercept of the consumption function. C1 is the marginal propensity to consume, Y is the
real GDP and G is the taxes imposed by the government on the economy.
(b)

The investment function

Investment consists of spending on new buildings, factories and new equipment, new
housing and net increases in inventories. For simplicity, we assume that investment is
autonomous, that is, the investment level is fixed regardless of the real GDP. Thus the
investment function is a horizontal line.
Figure 10.2: Investment Function
Investment

Investment Function

I0

Real GDP
A typical investment function is shown in Figure 10.2. Mathematically, the expression of
the investment function is I = I0.
(c)

Government Expenditure Function

The third component of aggregate expenditure is the government expenditure. This

consists of spending on national defence such as weapons and military machines,
spending to maintain law and order such as building of court and police force, spending
to engage teacher to provide teaching services, among others. The government purchase
function relates government purchases to the level of income in the economy. For

123

simplicity, we assume that government expenditure function is autonomous, or

independent on the level of real GDP.
Figure 10.3: Government Expenditure Function
Government Expenditure

Government Expenditure Function

G0

Real GDP
A typical government expenditure function is shown in Figure 10.3. Mathematically, the
expression of the government expenditure function is G = G0.
(d)

The Net Export Function

Net export means total value of export of goods and services minus the total value of
import of goods and services. The net export function shows the relationship between net
exports and the real GDP of the economy. For simplicity, we assume that the net export
function is autonomous, or independent of the level of real GDP. However, the level can
be positive or negative. It is positive if export exceeds import and negative if import
exceeds export.
Figure 10.4: Net Export Function
Net Export

Net Export Function

NX0

Real GDP
A typical net export function is shown in Figure 10.4. Mathematically, the expression of
the net export function is NX = NX0.

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(e)

The Aggregate Expenditure Function

Recall that aggregate expenditure AE = C + I + G + X - M. By combining the

consumption function, the investment function, the government expenditure function and
the net exports function, we have the aggregate expenditure function. A typical
aggregate expenditure function is shown in Figure 10.5.
Figure 10.5: Aggregate Expenditure Function.
Aggregate Expenditure
AE Function

AE0
Real GDP
The aggregate expenditure function is plotted with aggregate expenditure against the real
GDP of the economy. It is upward sloping because consumption increases with real GDP
but the other components are autonomous. Thus the shape of the aggregate expenditure
function follows the shape of the consumption function except that its level increases by
the autonomous investment, government expenditure and net export. The slope of the
aggregate expenditure function is marginal propensity to consume.
The Consumption function is plotted with disposable income while the other expenditure
components are plotted with real GDP. For consistency, we also adjust the intercept of
the consumption function so that it is expressed as a function of real GDP (Y) instead of
the disposable income YD. For simplicity, we assume that the taxes T is a lump sum tax
which is also autonomous, equals to an amount T regardless of the level of real GDP.
Mathematically, we have
C = C0 + C1YD
C = C0 + C1(Y T)
C = C0 + C1Y C1T = C0 C1T + C1Y
Together with the investment function I = I0, the government expenditure function G =
G0, the net export function NX = NX0, we can derive the aggregate expenditure function
as

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AE = C + I + G + NX
= C0 C1T + C1Y + I0 + G0 + NX0
= C0 C1T + I0 + G0 + NX0 + C1Y = AE0 + C1Y
3

Determination of Equilibrium Output

The aggregate expenditure shows the total spending of goods and services in the
economy. The real GDP shows the total amount of goods and services produced in the
economy. Keynes believe that in the short run if price level is fixed, the economy will be
at equilibrium if total expenditure equals to total output or AE = Real GDP.
The equilibrium point is determined by the intersection point of aggregate expenditure
function with a 45 degree line. This is shown as point A of Figure 10.6 and the
equilibrium real GDP is YE. This diagram is known as the Keynesian Cross Model.
Figure 10.6: Keynesian Cross Model
Aggregate Expenditure
AE Function
A
AE0
450 line

Real GDP (Y)

Y2

YE

Y1

If the aggregate expenditure is higher than real GDP, say at Y1, it implies that total
spending in a year is higher than total output produced in the same year. Therefore
producers must reduce their inventories in order to satisfy the excess demand. As
producers cannot allow their inventories to deplete continuously, they will have to
increase their productions. Thus real GDP increases until it is equal to the aggregate
expenditure.
If aggregate expenditure is lower than real GDP, say at Y2, it implies that total spending
in a year is lower than total output produced in the same year. Therefore producers must
have accumulated inventories since there is excess supply of goods. This will prompt the
producers to decrease their productions. Thus real GDP decreases until it is again equal
to the aggregate expenditure.
Mathematically, the equilibrium real GDP can be established by equating Y with AE.

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At equilibrium, Y = AE
Y = C + I + G + NX
= C0 C1T + C1Y + I0 + G0 + NX0 = AE0 + C1Y
Y C1Y = AE0 Y(1 C1) = AE0
Y = AE0 .
1 C1
4

Fiscal Policy

Given a fixed price level, the Aggregate expenditure function AE = C + I + G + X M

determines the equilibrium level of real GDP in the economy. Any shift in the aggregate
expenditure function has very important effect on the equilibrium real GDP in an
economy.
When any of the components of aggregate expenditure C, I G or NX increases, the
aggregate demand increases and the AE curve shifts upwards. It will intersect the 45
degree line at a higher level of real GDP, thus equilibrium real GDP increases and
expansion increases.
Similarly, when any of the component of spending C, I, G or NX decreases, the aggregate
expenditure decreases and the AE curve shifts to the left. It will intersect the 45 degree
line at a lower level of real GDP, thus equilibrium real GDP decreases and recession
occurs.
Keynes believed that an economy may run into a recession due to insufficient aggregate
expenditure and may be caught in the recession for a long period of time because price is
in general rigid. To bring an economy out of the recession, it is important for the
government to implement suitable policies.
4.1

Instruments of Fiscal Policy

Among the components of aggregate expenditures, the component G is under the direct
control of the government. Thus the government can influence AE by changing G. The
other component that is indirectly affected by government policy is the taxes T. When
taxes change, the consumption function will change and thus the AE will be affected.
Fiscal policy is the deliberate manipulation of government expenditure and taxes in order
to influence the economy. The objectives are to promote economic growth, reduce
unemployment and control inflation.
When government spending increases and taxes decrease, aggregate demand increases.
This is known as expansionary fiscal policy. The objective of implementing this policy is
to reduce unemployment and increase real GDP.

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When government spending decreases and taxes increase, aggregate demand decreases.
This is known as contractionary fiscal policy. The objective of implementing this policy
is to control inflation.
4.2

Changes in Government Expenditure

Consider an increase in government spending from an initial amount G0 to a higher

amount G1. This will increase the aggregate expenditure, thereby shifting the AE
function from AE to AE. The effects are shown in Figure 10.7
Figure 10.7: Increase in Government Spending
Aggregate Expenditure
AE = C + I + G1 + X - M

AE = C + I + G0 + X - M

AE1
A
AE0
450 line

Real GDP
Y0

Y1

Initially, the economy is at equilibrium at point A, and the equilibrium real GDP is Y0.
When the government expenditure increases, it will increase the AE. This will bring the
equilibrium real GDP to a higher level at Y1. Thus an expansion occurs. Hence with
sufficient increases in the government expenditure, the economy may be able to get out
of recession.
4.3

Changes in Taxes

Assume that the taxes imposed by the government are lump sum taxes equivalent to an
amount T and they are independent on the real GDP.
A decrease in taxes increases
disposable income at each level of real GDP and so consumption increases.
Recall that transfer payments are outright grants from governments to households. When
there is an increase in transfer payment, its effects is the same as a decrease in taxes since
it increases disposable income and thereby increases consumption in the economy.

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Initially, the economy is at equilibrium at point A, with the lump sum taxes amount at T0
which creates an amount of consumption C(T0). At equilibrium Y = AE and thus the
equilibrium real GDP is Y0. This is shown in Figure 10.8.
Figure 10.8: Decrease in Taxes
Aggregate Expenditure
AE = C(T1) + I + G1 + X - M

AE = C(T0) + I + G + X - M

AE1
A
AE0
450 line

Real GDP
Y0

Y1

When the government decreases the lump sum taxes to T1, the disposable income
increases and this will lead to the consumption increases to C(T1). Thus AE increases
and the AE function shifts up. This will bring the equilibrium real GDP to a higher level
at Y1and an expansion occurs. Hence with sufficient decreases in the taxes, the
government may also bring an economy out of recession.
5

Fiscal Policy and Budget Position

To implement expansionary fiscal policy such as increasing the government expenditure,

the government will need to obtain funds to finance its expenses.
The main source of government revenue is through tax collection. The other sources are
selling goods and services such as land and postal services and collecting fines, stamp
duties, licence fees etc.
The bulk of government expenditures is to maintain the various ministries and statutory
board to ensure that they functions effectively. The other expenditures include transfer
payments to welfare recipients; donate to foreign countries in the form of foreign aid
(usually for developed economies to developing economies or during crisis such as
natural disasters) and building infrastructure such as roads, airports and providing public
goods such as street lights and parks.

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5.1

Budget Deficit

When the total revenue collected is not enough to finance the expenditures incurred by
the government, there is a budget deficit.
To solve the budget deficit, there are three methods:
(1)

Reduce expenditures but this measure is very unpopular

(2)

Increase taxes and this measure is depressionary and is equally unpopular

(3)

Borrowing but this incur debts and eventually need to pay back

5.2

Budget Surplus

When the total revenue collected is higher than the total expenditures incurred by the
government, there is a budget surplus. Budget surplus usually means people are tax more
than necessary to finance the government spending, and hence it could be recessionary.
But the positive effect of a budget surplus is that it will provide funds for future spending
and government need not compete with private sector for limited funds.
5.3

Balanced Budget

When the total revenue collected is the same as the total expenditures incurred by the
government, there is a balanced budget.
In general, it does not mean that a balanced budget position is always preferred to a
budget deficit or a budget surplus. While a severe budget deficit can be a drain on the
countrys resources, a small budget deficit when the government borrow to finance
infrastructure development can bring long term benefits to an economy. A government
that runs a budget surplus will have more funds for emergency but it can be
contractionary to the economy if the surplus is huge and persistent.

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6.

Discussion Questions

Question 1
What are the effects on the economy when there is an increase in corporate tax rate?
Consumption increases and AE increases
Consumption decreases and AE decreases
Investment increases and AE increases
Investment decreases and AE decreases
Question 2
Given that consumption is $80 when disposable income is $100 and that consumption is
$150 when disposable income is $200, the MPC is
(a) 0.3
(b) 0.5
(c) 0.7
(d) 0.9
Question 3
Which of the following is not the objective of government implementing expansionary
fiscal policy?
(a) To create jobs
(b) To promote economic growth
(c) To raise GDP of an economy
(d) To control inflation
Question 4
Given that MPC is 0.8, which of the following statement is correct?
(a)
(b)
(c)
(d)

The MPS must be 0.4

The consumption function will be downward sloping
When disposable income increases by $1, consumption will decrease by 80 cents.
When disposable income increases by $1, consumption will increase by 80 cents.

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Question 5
According to the Keynesian Cross Model, if AE exceeds real GDP, then
(a)
(b)
(c)
(d)

price level will increase until AE = real GDP

there will be a recession in an economy
the depletion of inventory leads firms to increase real GDP until it equals AE
pressure will occurs for AE to decrease until it equals real GDP.

Question 6
Knowing that a contractionary fiscal policy will reduce real GDP and may cause
recession, why would government still want to implement such a policy?
Question 7
Explain with suitable Keynesian Cross diagram how the government can use
expansionary fiscal policy in the form of a tax cut to bring an economy out of recession

132

ELEMENTS OF ECONOMICS
SESSION 11
MONEY AND MONETARY POLICY
At the end of the session, students should be able to:
1.
Define money and explain its functions.
2.
Explain the money creation process and derive the money multiplier.
3.
Define money demand and money supply.
4.
Explain how central bank can influence the money supply.
5.
Explain how the equilibrium interest rate is established.
6.
Explain the mechanism of monetary policy.
____________________________________________________________________
1.

Introduction

In this session, we first discuss the definition and function of money. Next we briefly
introduce the financial institutions system and commercial banks, in particular the money
creation process by the commercial banks. Then we discuss the demand for and the
supply of money which forms the money market. Finally we discuss the mechanism and
the effects of monetary policy on an economy.
2

Money and its Functions

In the beginning there was no money. Households produced all its consumed and
consumed all its produced and there was little need for exchange.
When specialization emerged, the specialization of labour resulted in exchange. The
kinds of good traded were limited and people could easily exchange their products
directly for other products. This system is called barter.
Barter depends on a double coincidence of wants, which occurs only when a trader is
willing to exchange his products for what another offers. Traders must also agree on a
rate of exchange. Increased specialization and number of products offered made barter
system of exchange more time consuming and more cumbersome.
2.1

The Evolution of Money

Over time, the traders discovered that there were certain goods which are very popular
for exchange. So traders began to accept certain goods, not for immediate consumption
but because these goods would be accepted by others and could be re-traded later. These
goods began to function as money.

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The form of money also changes over time. Initially it takes the form of commodity, then
develop into the form of precious metal. Currently it is in the form of paper and coins
and eventually it may be in electronic form.
2.2

Functions of money

Money fulfils four important functions. They are discussed as follows.

(a)

Medium of Exchange

A medium of exchange is anything that is generally accepted in payment for goods and
services sold. Whatever serves as a medium of exchange is called money. Without this
medium of exchange, transactions can only carry out in the form of barter trade which
requires a double coincidence of wants. If a commodity is accepted by everyone in
exchange for whatever is sold, traders can save much time, disappointment and sheer
aggravation. The person who accepts this commodity in exchange for some products
believes that this commodity can be used later to purchase whatever is desired. The
commodities that have been used as money are corn, shells, cattle, tobacco and precious
metals. These are called commodity money.
(b)

Unit of Account

As one commodity becomes widely accepted, the prices of all other goods come to be
quoted in terms of that good. The chosen commodity becomes a common unit of
account, a standard unit of quoting prices. Rather than having to quote the rate of
exchange for each good in terms of every other good, as is the case in a barter economy,
people can measure the price of everything in terms of that particular commodity.
(c)

Store of Value

Because people often do not want to make purchases at the time they sell an item, the
purchasing power acquired through sales must somehow be preserved. Money serves as
a store of value when it retains purchasing power over time.
(d)

Standard of Deferred Payment

People often borrow to finance expenditures and save for future expenditures. These
commitments to pay an amount in the future or receive payment in the future are
specified in money. Money thereby serves as a standard of deferred payment to specify a
future amount, enabling people to contract for future payments and receipts.

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Financial Institutions and Commercial Banks

Financial institutions attract the funds of savers and lend these funds to borrowers,
serving as intermediaries between savers and borrowers. Thus they are also called
financial intermediaries. They earn a profit by `buying low and selling high, paying a
lower interest rate to savers than they charge borrowers.
Commercial banks are the oldest, largest and most diversified of financial institutions.
They gather various amounts from savers and package these funds into the amount
demanded by borrowers. Banks also match up the preferred duration of savers with those
of borrowers.
The practices of commercial banks are governed by the central bank. The central bank
plays the supervisory role of the commercial banks and other financial institutions. The
objective of the central bank are to control inflation, promote economic growth and to
ensure stability in the banking and financial industry so that the banks can operate
efficiently. It will enact rules and regulations which the commercial banks must follow
in order to operate in the economy.
3.1

Reserves in Commercial Banks

When a commercial bank accepts a deposit, it is obliged to repay the depositors that
amount whenever requested by the depositors. But the bank is also a profit oriented
organisation and it makes profit by lending money to borrowers. So the commercial
banks must keep a portion of the depositors' money in the banks to meet the depositors
requirement and can lend out the balance.
To ensure that the commercial banks keep sufficient reserves, the central bank will
determine a certain percentage of their deposits to be kept as reserves and the commercial
banks must follow this requirement. This percentage is called the required reserve ratio
(r) which is the proportion of deposits the commercial banks must hold in reserve. The
dollar amount that must be held in reserve is called required reserves.
Excess reserves are reserves kept by banks that are in excess of the required reserve.
Since excess reserves are not profitable but incurs a cost, we assume that all banks do not
keep excess reserves.
3.2

Money Creation Process

To illustrate the money creation process, assume for simplicity that there is only one
commercial bank, known as Bank A in the economy. Suppose an individual X deposits
currency of $100,000 in Bank A. If the reserve requirement ratio (r) is 10%, Bank A
must keep 10% of $100,000 = $10,000 as required reserve. The balance of $90,000 Bank
A can lend out to the public to make profits.

135

Suppose another individual Y approaches Bank A to borrow $90,000. With the $90,000,
the individual Y will spend it to purchase the goods or services he desires. Assume there
is no cash leakage in the economy. This means whoever receive the money from
Individual Y will deposit back to the commercial bank, which is Bank A. Bank A will
treat this amount of money as new deposits and will record that its deposits increase by
$90,000. Bank A will needs to keep 10% of $90,000 = $9000 as required reserve and can
lend out the balance of $81,000.
Suppose a third individual Z borrowed $81,000 from Bank A and again spend it on
whatever goods or services he desires. Again whoever receives the money from
Individual Z will deposit the money into Bank A. Bank A will treat this money as new
deposits. It will keep 10% of $81,000 = $8100 as required reserves and lend out the
balance of $72,900. This process will continue until no more deposits increase in the
banks and no more money created.
In total the commercial bank's deposits will add up to $1,000,000, which is 10 times the
original amount of deposits $100,000. The amount of deposits actually multiplied 10
times. Out of this $1,000,000, only $100,000 represents the currency printed by the
central banks for circulation in the economy. The other $900,000 are created by the
commercial bank.
3.3

The Money Multiplier

We can use the money multiplier to calculate the total amount of deposits (and hence
money) eventually in the economy.
The money multiplier equals to the reciprocal of the required reserve ratio. That is,
Money multiplier = 1/r, where r is the required reserve ratio
With an increase in deposits of $10,000 and a required reserve ratio of 10%, the money
multiplier is 1/(0.1) = 10. Thus in total the deposits will become $100,000 eventually.
Out of this $100,000 created, $90,000 is the increase in loans which is created by the
commercial banks while the $10,000 is the original deposits.
If the required reserve were 20% instead of 10%, each bank would have to set aside twice
as much for required reserves. The money multiplier is 1/(0.2) = 5 and the total money
created is $50,000. Thus the amount of new money created decreases.
If banks decide to keep excess reserves, the amounts of loan they extended will be
smaller, and hence the amount of money created will also be smaller.
If depositors prefer to hold cash and starts withdrawing cash from the bank, the bank will
have lesser deposits and hence the amount of new money created will also decrease.

136

Money Demand

Consumers need money to buy products, and firms need money to buy resources. Money
allows people to carry out their economic transactions more easily, The demand for
money needed to support exchange is called the transactions demand for money.
Money is more than a medium of exchange, it is also a store of value. Assumed that
people store their purchasing power in either cash or deposits with the commercial banks
which offer interest to depositors. The opportunity cost of holding cash rather than
financial assets is the interest forgone.
The demand for money is a relationship between how much money people desire to hold
and the interest rate. People express their demand for money by holding some of their
wealth as money rather than holding other assets that would earn a higher rate of return.
When the market interest rate is low, other things constant the cost of holding cash is also
low. So people hold a larger fraction of their wealth in the form of cash.
When the market rate of interest is high, the cost of holding money is high, so people
hold less of their wealth in money (cash) and more of their wealth in other financial
assets that pay more interest.
The quantity of money demanded varies inversely with the market interest rate. The
money demand curve is downward sloping. This is shown in Figure 11.1
Figure 10.1: Money Demand Curve
Interest Rate

r0

r1
Money Demand Curve
Q1

Q0

137

Quantity of money
demanded

The factors that are held constant along the curve are the price level and real GDP. If
either factor changes, the money demand curve will shift. This is shown in Figure 10.2.
When the price level increases, consumers will need more money to carry out the same
transactions as before. Thus the money demand increases at each level of interest rate
and the money demand curve shifts right.
When real GDP increases, the income of the people in the country in general increases
and they will want to buy more goods and services. To carry out more transactions, they
will need to demand for more money. Thus the money demand increases at each level of
interest rate and the money demand curve shifts right.
Figure 10.2: Increase in Money Demand
Interest Rate

r0
MD2
MD1
Q1

Q0
5

Quantity of money
demanded

Money Supply

Money supply refers to the stock of money available in the economy at a particular time.
5.1

Definitions of Money Supply

There are three common definitions of money supply defined by the Central Bank. The
three common monetary aggregates are M1, M2 and M3:
M1 consists of currency and demand deposits (current account).
M2 consists of M1, negotiable certificate of deposits, saving deposits and fixed deposits

138

M3 consist of M2 and deposits in non-bank financial institutions

Demand deposits are so called because a depositor with such an account can write a
cheque to demand those deposits at any time. They are also called checkable deposits
and do not earn interest. In the context of Singapore, it is known as current account.
Fixed deposits earn interest and have a specific maturity rate. The interest rate is always
higher than the saving deposit interest rate.
Savings deposits earn interest but have no specific maturity date. Deposits can withdraw
their money at their wish.
Thus M3 > M2 > M1.
5.2

Money Supply Curve

We assume that the central bank has full control over the money supply and can
determine its quantity regardless of the interest rate. Thus the money supply curve is a
vertical line, as shown in Figure 10.3.
Figure 10.3: Money Supply Curve
Interest Rate
Money Supply Curve

r0

r1

Quantity of money
supplied

Q0
5.3

Methods to Change Money Supply

We assumed that the money supply is determined by the central bank. This means the
central bank can determine the desired quantity of money available in the economy,
regardless of the interest rate. When central bank increases money supply, the money

139

supply curve shifts right. When central bank decreases money supply, the money supply
curve shifts left. This is shown in Figure 10.4
Figure 10.4: Shifts in Money Supply Curve
Interest Rate
MS2

Q2

MS0

MS1

Q0

Q1

Quantity of money
supplied

There are three methods which the central bank can influence the supply of money.
(a)

Open Market Operation

The first method is by conducting open market operations. Open market operations is the
buying and selling of government bonds by the central bank. When the central banks buy
government bonds from the commercial banks, it will pay the commercial banks a sum of
money in exchange for the bonds. With that sum of money the commercial bank can
generates more money by the multiplier process and hence the money supply will
increase.
(b)

Reserve Requirements

The second method to influence the money supply is to change the reserve requirement.
If the central bank increases the reserve requirement, then the commercial bank will have
to keep more reserves and lend out less money. Thus the money multiplier effect will be
smaller and the money supply will reduce.
(c)

Discount Windows

The third method is through setting the discount rate. Discount rate is the interest rate
charged by the central bank to the commercial banks. If the central bank reduces the
discount rate, it becomes cheaper for the commercial bank to borrow money from the

140

central bank. With more money, the commercial bank can expand the money creation
process further and hence increase the money supply.
6

Money Market and Monetary Policy

The money demand and money supply forms the money market which determines the
interest rate in an economy. The intersection of the supply of money and the demand for
money determines the equilibrium rate of interest. It is the rate that equates the quantity
of money supplied in the economy with the quantity of money demanded. This is shown
in point A at Figure 10.5 and the equilibrium interest rate is r0 when the money supply is
Q 0.
Figure 10.5: Money market Equilibrium
Interest Rate
Money Supply Curve

A
r0

Money Demand Curve

Quantity of money
Q0
6.1

Effect of Money Supply Changes

If the government increases the money supply (say by reducing the required reserve
ratio), the money supply curve shifts to the right. At the existing interest rate, the
quantity supplied of money now exceeds the quantity demanded. Thus interest rate falls
until the quantity demanded just equals the quantity supplied. On the other hand, if the
money supply were to decrease, the interest rate will increase. This is shown in Figure
10.6.

141

Figure 10.6: Effects of Money Supply Change

Interest Rate
MS2

r2

MS0

MS1

E2
E0

r0

E1

r1

Quantity of money
Q2
6.2

Q0

Q1

Monetary policy

Monetary policy is the policy which affects the money supply in the economy. The
policy influences the market rate of interest, which in turn affects the level of investment,
a component of aggregate expenditure.
Expansionary monetary policy means government increases the money supply in the
economy. Contractionary monetary policy means government reduces the money supply
in the economy.
Besides implementing open market operations, adjusting the required reserve ratio and
the discount rate, the central bank can also influence the money supply to the desired
level. This process will trigger a series of changes in the economy which eventually
affects the real GDP and the price level of the economy. This is known as the
transmission mechanism of monetary policy
(a)

Money Supply and Aggregate Expenditure

Assume that the government believes that the economy is operating well below its
potential output level. It can increase money supply to stimulate output and employment.
The links between changes in the money supply and changes in aggregate expenditure is
shown in Figure 10.7

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When the money supply increases, the money supply curve shifts to the right from MS0
to MS1. This will reduce the market rate of interest from r0 to r1.
Figure 10.7: Effects of Money Supply Increases
Interest Rate
MS1

MS0

E0

r0

E1

r1

Quantity of money
Q0

Q1

A decline in the market rate of interest from r0 to r1 reduces the opportunity cost of
financing new houses, plants and equipment, making new business investment more
profitable and the investment level will increase. Thus investment increases from I0 to I1,
as shown in the movement along the investment demand curve from point A to point B.
Figure 10.8: Effects on Investment Demand
Interest Rate

r0

r1

Investment Demand Curve

Quantity of Investment
I1

I0

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Since investment is a component of aggregate expenditure, the higher investment level

raise the aggregate expenditure curve by the amount of the increase in investment. At
equilibrium, real GDP equals AE and hence real GDP also increases from Y0 to Y1, as
shown in Figure 10.9.
Figure 10.9: Effects on Aggregate Expenditure
Aggregate Expenditure
AE = C + I1(r1) + G1 + X - M

AE = C + I0(r0) + G + X - M

AE1
A
AE0
450 line

Real GDP
Y0

Y1

If the government decides to reduce the money supply to cool down an overheated
economy, the interest rate will increase. At the higher interest rate, firms find it more
costly to finance investment and hence investment decreases. This will decrease the
aggregate expenditure, shifting the AE curve downwards. The result is a lower real GDP
which will result in a lower price level. This is known as a contractionary monetary
policy.
As long as the interest rate is sensitive to changes in the quantity of money supplied, and
as long as investment is sensitive to changes in the interest rate, monetary policy is
effective in affecting the real GDP of the economy.
However, since the Keynesian Cross Model is based on a fixed price level, it is not useful
to analyze the effect of a contractionary monetary policy. This is more effectively
analysed using the aggregate demand and aggregate supply framework discussed in
Session 12.

144

Discussion Questions

Question 1
Assume required reserve ratio of 20% and no cash leakage, how much money is created
from an initial deposit of $500
(a) $1000
(b) $1500
(c) $2000
(d) $2500
Question 2
What are the effects on the money market when price level increases?
(a) money supply and interest rate increase
(b) money supply and interest rate decrease
(c) money demand and interest rate increase
(d) money demand and interest rate decrease
Question 3
What are the effects on interest rate and investment when money supply decreases?
(a) interest rate and investment increase
(b) interest rate and investment decrease
(c) interest rate drops and investment rises
(d) interest rate rises and investment drops
Question 4
What happen to the money market when central bank sells bonds?
(a) money demand increases
(b) money demand decreases
(c) money supply increases
(d) money supply decreases
Question 5
Under what situation will monetary policy be totally ineffective?
(a) Money demand curve is downward sloping
(b) Investment demand curve is downward sloping and flatter
(c) Investment demand curve is downward sloping and steeper
(d) Investment demand curve is perfectly inelastic

145

Question 6
(a)
Explain the money creation process by considering the required reserve ratio is
5%, the Initial deposit is $800 and there is no cash leakage.
(b)

Derive the money multiplier

(c)
What will happen to the money created if the required reserve ratio increases to
25% and the other information remains unchanged?

Question 7
(a)
Explain with suitable diagrams the transmission mechanism of an expansionary
monetary policy
(b)
What will happen to the effectiveness of this policy if investment is not sensitive
to interest rate at all?

146

ELEMENTS OF ECONOMICS
SESSION 12
AGGREGATE DEMAND AND AGGREGATE SUPPLY
At the end of the session, students should be able to:
6.
Define and explain the influences on aggregate demand.
7.
Define and explain the influences on aggregate supply.
8.
Explain the equilibrium in the economy.
9.
Analyse changes in aggregate demand and aggregate supply.
10.
Apply the aggregate demand aggregate supply framework to analyze economy
________________________________________________________________________
1.

Introduction

In this session, we begin with a discussion of aggregate demand. Next, we analyse and
discuss the aggregate supply. Then we combine the two together to analyse the effect of
changes in aggregate demand and aggregate supply in an economy. Finally we apply the
aggregate demand and aggregate supply framework to analyze the effects on the
economy.
2

Aggregate Demand

The aggregate demand (AD) curve shows the relationship between the average price level
of all goods and services in the economy and the quantity of all goods and services
demanded, other things constant. The AD curve reflects an inverse relationship between
the price level in the economy and the quantity of aggregate output demanded.
Aggregate demand (AD) refers to the total demand for goods and services in an economy
at different price level. Price level is the average of all prices in the economy. From the
law of demand, when price of a product decreases the quantity of the product demanded
will increase. This is true for one product and is also true for all products considered
together.
Thus when price level decreases, the quantity of all products demanded increases. On the
other hand when price level increases, the quantity of all products demanded decreases.
Thus the aggregate demand curve is a downward sloping schedule. A typical aggregate
demand curve is shown in Figure 12.1. When price level decreases from P1 to P2, the
total output demanded increases from Y1 to Y2.

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Figure 12.1: Aggregate Demand Curve

Price Level
A
P1
B

P2

Aggregate Demand curve

Y2

Y1
2.1

Real Output demanded

Components of Aggregate Demand

Recall in Session 10 when we analyze the aggregate expenditure, we divide the

expenditures into 4 components incurred by the 4groups : the households, the firms, the
government and the foreigners. Thus the aggregate demand for output consists of the
demand by these four groups of participants.
Households spending is on consumer goods and this type of spending is called
consumption (C). Firms mainly spend on building factories, office and equipment and
this type of spending is investment (I). Government incurred spending to provide public
goods and services and this spending is known as government expenditure (G). When
foreigners purchase local products the spending incurred is known as export (X). When
local purchases foreign products this is known as import (M). In analysing an economy,
the interest is on domestically produced goods and services and hence we analyze the net
export NX which is export minus import.
Thus aggregate spending consists on all spending except those on imported goods.
Hence the equation for aggregate demand is AD = C + I + G + NX
When the price level changes, it will only result in a movement along the same aggregate
demand curve. When other factors that affect C, I, G and NX change, the aggregate
demand curve will shift.
(a)

Consumption

Consumption increases as income increases. But there are other factors that also affect
consumption in an economy.

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(i)

Wealth

Wealth is the value of all assets that each household owns, such as house, cars, money in
the bank, stocks and bonds etc. If the wealth level increases, consumption will increase
even though households income remain unchanged. Thus when there is a stock market
boom or a property market boom, we will expect consumption to increase and hence
aggregate demand increases.
(ii)
Interest rate : Interest is the reward paid to savers to defer consumption and the
amount paid by borrowers for current spending power. If the interest rate increases,
savers are rewarded more and consumers are encouraged to save more and spend less.
Thus the households consumption decreases.
(iii) Consumer confidence : If consumers are confidence of a good time ahead and
their future income are likely to increase, their consumption level will increase.
(b)

Investment

Investment consist of spending on new factories and new equipment, new housing and
net increases in inventories. The factors that affect investment are as follows:
(i)
Interest rate : Investment is based on a given interest rate. If the interest rate
increases, the cost of borrowing increases and this increases the opportunity cost of
investment. The opportunity cost of investment is to put the money in the bank to earn
the higher interest. The result is a decrease in the level of investment. The investment
function will shift downwards.
(ii)
Business expectations : If firms in general are more pessimistic about profit
prospects or they are expecting a recession, their investment will decrease at every level
of income. The investment function will shift downwards.
(c)

Government Spending

The government purchases ranging from weapon systems to street cleaning. The
government purchase function relates government purchases to the level of income in the
economy. Government spending is solely at the discretion of the government.
(d)

Net Export

Net export means total value of export of goods and services minus the total value of
import of goods and services. The factors that affect net exports are as follows:

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(i)
Foreign income level : If the income of foreigners increase, they will import
more from the local country and hence local export increases. The net export will
therefore increase.
(ii)
The exchange rate : If local currency becomes stronger (appreciate), this will
make exports more expensive and imports cheaper, thus give rise to a lower net export.
If local currency becomes weaker (depreciate), exports will become cheaper and imports
more expensive. This will increase the net export.
(iii) The local and foreign interest rate : If local interest rate is higher, more foreigners
will want to lend to local country. They will exchange their currency with the local
currency. There will be an appreciation of local currency, results in a lower net export.
Hence when factors such as net wealth, local and foreign interest rate, consumer
expectations, business expectations, government spending, taxes, transfer payment,
foreign price and income level, exchange rate changes, the aggregate demand curve will
shift. If the change is a positive factor, the AD curve will shift to the right. If it is a
negative factor that change, the AD curve will shift to the left. This is shown in Figure
12.2.
Figure 2.2: Changes in Aggregate Demand
Price Level

P0

Y1
3

Y0

AD1
Y2

AD0 AD2
Real Output Demanded

Aggregate Supply

Aggregate supply refer to the supply of all output by all firms in the economy at different
price level. Law of supply indicates that as price of a product increases, the quantity of
the product supplied will increase, other things equal. But since production require
resources and at any time the quantity of resources in an economy is fixed, the quantity of
output will reach a maximum when all resources are fully utilised.
For aggregate supply, the time frame is important. Thus there is a need to distinguish
between short run and long run aggregate supply. In the short run, the assumption is that
not all resources are fully utilised. It is possible to increase output produced by hiring

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more resources. Firms will have incentives to produce more output if the price level
increases. Thus in the short run, as price level increases real output supplied also
increases. The short run aggregate supply is upward sloping.
Figure 12.3: Aggregate Supply Curve (Short Run)
Price Level
B

Aggregate Supply Curve

(Short Run)

P2
P1

A
Y2

Y1

Real Output Supplied

But in the long run, all resources are fully utilised since resources are scarce. It will be
irrational to leave valuable resources unutilised in the long run since resources can be
used to produce more output. When all resources are fully utilised, the economy will
produce at its potential output level, or full employment output level. Even if consumers
are willing to pay a higher price for all output, no further output can be produced since
there are no more resources available. Thus the long run aggregate supply curve is
vertical at the potential output level. This is shown in Figure 12.4 where the actual output
is always at the potential output Yp regardless of the price level.
Figure 12.4: Aggregate Supply Curve (Long Run)
Price Level
Aggregate Supply Curve
(Long Run)
P2
P1
Real Output Supplied

YP

In this module, we will focus on the short run situation and hence the aggregate supply
curve is upward sloping.

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3.1

Factors Affecting Aggregate Supply

If there is a change in the price level which induces firms to produce different quantities
of output, it will be reflected as a movement along the AS curve. But if there is a change
in other factors that affect the producers output, then the aggregate supply curve will
shift.
The factors that affect the aggregate supply are as follows:
(a)
Resource owners willingness and ability to supply resources
If resource owners are more willing to supply resources, such as a change in taste towards
work, then the aggregate supply curve will shift to the right.
(b)
The state of technology
If there is an improvement in the level of technology, then producers will be able to
supply more products and the aggregate supply curve will shift to the right.
(c)
The cost of production
It is assumed that the price of raw materials, such as oil, the rental cost, the interest and
wages are held constant when we draw an aggregate supply curve. If any of the cost of
production were to increase, the aggregate supply curve will shift to the left.
Whenever any of the factors that affect the aggregate supply change, the aggregate supply
curve will shift. If the change is a favourable one, then the aggregate supply curve will
shift right. If the change is a non-favourable one, the aggregate supply curve will shift to
the left. This is shown in Figure 12.5.
Figure 12.5: Changes in Aggregate Supply
Price
AS1

AS0

AS2

P1

Y1
4

Y0

Y2 Real Output Supplied

Equilibrium in an Economy

The intersection of the aggregate demand and aggregate supply curves determine the
equilibrium levels of price and aggregate output in the economy.

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In Figure 12.6, given the aggregate demand and the aggregate supply curve, the economy
is at equilibrium at point E. The equilibrium price level is PE and the equilibrium real
GDP is YE.
Figure 12.6: Equilibrium in the Economy
Price Level
Aggregate Supply curve
PE

Aggregate Demand curve

Real GDP

YE

When factors which affect aggregate demand and aggregate supply curve change, the
aggregate demand and aggregate supply curve will shift. This will in turn affect the
equilibrium point in the economy.
4.1

Impact of Changes in Aggregate Demand

Since AD = C + I + G + X - M, any factors which influence C, I, G, X or M will affect

aggregate demand and shifts the AD curve. Consumption is mainly influenced by
disposable income (income less taxes). When disposable income increases, consumption
increases. Investment is mainly influenced by interest rate. When interest rate decreases,
firms will borrow more and invest more. But when interest rate increases, the cost of
borrowing increases. Firms will borrow less and invest less.
Government spending is assumed to be at the sole discretion of the government and not
influenced by any factors. Export and import are influenced by income level and
exchange rate. When domestic income increases, import will increase but when foreign
income increases, export will increase. On the other hand, when domestic currency
appreciates (stronger), import becomes cheaper and export is more expensive. This leads
to a lower export and a higher import. Conversely, when domestic currency depreciates
(weaker), export becomes cheaper and import more expensive. This will result in a
higher export and lower import.
If aggregate demand increases, the aggregate demand curve shifts right. This will result
in a higher price level and a higher real GDP in an economy. If aggregate demand
decreases, the aggregate demand curve shifts left. This will result in a lower price level
and a lower real GDP in an economy.

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Figure 12.7 shows the effect of an increase in aggregate demand on the economy. With
aggregate demand increases from AD1 to AD2, the equilibrium point change from E1 to
E2. Thus price level increases from P1 to P2 and the real GDP also increases from Y1 to
Y 2.
Figure 12.7: Increase in Aggregate Demand
Price Level
Aggregate Supply curve
P2
P1

E1

E2

AD1
Y1
4.2

Y2

AD2
Real GDP

Impact of Changes in Aggregate Supply

Aggregate supply of an economy depends on the price of resources, quantity of

resources, quality of resources and level of technology in a country. When there is an
increase in the quantity of resources, more output can be produced, aggregate supply
increases and hence the aggregate supply curve shifts to the right. Likewise, when there
is an improvement in the quality of resources, such as due to higher educational level
improves the human capital, then each worker can contributes more aggregate supply of
the economy increases. When there is an improvement in technology, with same amount
of resources more output can be produced, aggregate supply increases and this shifts
aggregate supply curve to the right.
In the event of a change in price of resources, the aggregate supply will also be affected.
When resources become more expensive, less resources will be hired and hence less
output produced. This shifts aggregate supply curve to the left. Conversely, when price
of resources decrease this will increase aggregate supply and shifts the aggregate supply
curve to the right.
The most important resource is an economy is its labour resource and the price of the
labour resource is the wage cost. In the short run when wage cost increases, firms will
respond by hiring less workers, other things equal. This result in lesser output produced
and short run aggregate supply decreases. But when wage cost decreases, the effect is
exactly opposite. Firms will have incentives to hire more workers. With more workers,
firms can produce more output and aggregate supply increases.

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If aggregate supply increases, the aggregate supply curve shifts right. This will result in a
lower price level and a higher real GDP in an economy. If aggregate supply decreases,
the aggregate supply curve shifts left. This will result in a higher price level and a lower
real GDP in an economy.
Figure 12.8 shows the effect of an increase in aggregate supply on the economy. With
aggregate supply increases from AS1 to AS2, the equilibrium point change from E1 to E2.
Thus price level decreases from P1 to P2 and the real GDP increases from Y1 to Y2.
Figure 12.8: Increase in Aggregate Supply
Price
AS1
P1

E1

AS2

P2

E2
Aggregate Demand Curve
Y1

Y2

Real GDP

Application of Aggregate Demand and Aggregate Supply Framework

Unlike the Keynesian Cross Model which assumes price level to be fixed, the aggregate
demand aggregate supply framework allows the price level to change, and hence it is
more useful in analyzing the effects of policy, in particular inflation.
5.1

AD-AS Framework on Inflation

Inflation can be depicted as a continuing increase in the economys price level resulting
from an increase in aggregate demand or a decrease in aggregate supply.
(a)

Demand-pull inflation

Inflation resulting from an increase in aggregate demand is called demand-pull inflation.

A rightward shifts in the AD curve pulls up the price level. The increase in AD leads to
both a higher price and output level. This is shown in Figure 12.9.

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Figure 12.9: Demand Pull Inflation

Price Level
Aggregate Supply curve
P2

E1

P1

E2

AD1
Y1
(b)

Y2

AD2
Real GDP

Cost-push inflation

Inflation resulting from a reduction in aggregate supply is called cost-push inflation. A

leftward shifts in the AS curve, suggesting that an increase in the cost of production has
pushed up the price level. This is shown in Figure 12.10.
Figure 12.10: Cost Push Inflation
Price
AS2
P2

E2

AS1
E1

P1

Aggregate Demand Curve

Y2
5.2

Y1

Real GDP

AD-AS Framework on Government Policy

When the government implement an expansionary fiscal policy such as increase in

government spending or a tax cut, it will lead to higher G or C. When the government
implement an expansionary monetary policy, it will lead to higher I. In both cases, the
effect is that aggregate demand increases, which creates an expansion in the economy
together with inflation. This is shown in Figure 12.11.

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Figure 12.11: Expansionary Fiscal or Monetary Policy

Price Level
Aggregate Supply curve
P2
P1

E1

E2

AD1
Y1

Y2

AD2
Real GDP

With aggregate demand increases from AD1 to AD2, the equilibrium point change from
E1 to E2. Thus price level increases from P1 to P2 and the real GDP also increases from
Y1 to Y2. Thus the government can implement expansionary fiscal policy or monetary
policy to bring an economy out of recession. The policies are also relevant to reduce
cyclical unemployment.
When the government implement a contractionary fiscal policy such as a decrease in
government spending or a tax increase, it will lead to lower G or C. When the
government implement a contractionary monetary policy, it will lead to lower I. In both
cases, the effect is that aggregate demand decreases, which creates a recession in the
economy but the price level will be lower. This is shown in Figure 12.12.
Figure 12.12: Contractionary Fiscal or Monetary Policy
Price Level
Aggregate Supply curve
P1
P2

E2

E1`

AD2
Y2

Y1

AD1
Real GDP

With aggregate demand decreases from AD1 to AD2, the equilibrium point change from
E1 to E2. Thus price level decreases from P1 to P2 and the real GDP also decreases from
Y1 to Y2. Thus the government can implement contractionary fiscal policy or monetary
policy to control inflation but in the process it may create a recession in the economy.

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Discussion Questions

Question 1
When there is an income tax cut,
(a) aggregate demand increases
(b) aggregate demand decreases
(c) aggregate supply increases
(d) aggregate supply decreases
Question 2
When there is a technological improvement,
(a) aggregate demand increases
(b) aggregate demand decreases
(c) aggregate supply increases
(d) aggregate supply decreases
Question 3
When price level increases,
AD curve shifts to the left.
AS curve shifts to the right.
Both AD curve shifts left and AS curve shifts right.
A surplus of output occurs which will push down the price level.
Question 4
Which of the following will cause the aggregate demand curve to shift?
(a) An increase in wages
(b) An increase in taxes
(c) An increase in saving
(d) An increase in foreigners income
Question 5
Which of the following occurs when the government increases money supply?
(a) An increase in aggregate supply
(b) A decrease in aggregate supply
(c) An increase in aggregate demand
(d) A decrease in aggregate demand

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Question 6
Explain using AD-AS framework the effects on an economy when the following occurs:
(a)
An improvement in technology
(b)
A tax cut
(c)
A deterioration in investors confidence
(d)
An increase in wages
Question 7
(a)
Consider Singapore and USA. If Singapore dollar becomes stronger relative to
US dollars, what do you think will happen to the economy? Analyze using the AD-AS
framework. (Note: Singapore dollar stronger means one dollar can exchange for more
US$)
(b)
How does an increase in oil price affect an economy? Analyze using the AD-AS
framework.

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